Math Problem Statement

Consider a single period model in a MM world: Executive Cheese currently has senior debt with a market value of $100m and has outstanding 15m shares with a market price of $10 per share. The cash flow of the company at the end of the period is either $150m in bad state or $350m in good state. Assume each state has equal probability of occurring. The company now announces that it intends to issue a junior debt with face value of $100m and use the proceeds to buy back common stock.

f. Suppose that there is a bankruptcy cost of $30m, what is the price of the stock per share after the announcement?

Solution

To calculate the price of Executive Cheese's stock per share after the announcement, we need to account for the bankruptcy cost and its impact on the cash flows and stockholder value in both the good and bad states of the world.

Step 1: Identify cash flows to debt and equity holders

  • Bad state cash flow: $150 million
  • Good state cash flow: $350 million
  • Senior debt market value: $100 million
  • Bankruptcy cost: $30 million
  • Face value of junior debt to be issued: $100 million
  • Shares outstanding before buyback: 15 million
  • Stock price before buyback: $10 per share

Step 2: Cash flow allocation in each state

  1. Bad state (Cash flow = $150 million):

    • Senior debt is paid first. Since $150 million is less than the total debt ($200 million), the company will go bankrupt.
    • Bankruptcy cost = $30 million, so the remaining cash flow after bankruptcy cost = 15030=120150 - 30 = 120 million.
    • Senior debt holders will receive all the remaining cash flow after bankruptcy, i.e., $120 million. Junior debt holders get nothing, and equity holders get nothing.
  2. Good state (Cash flow = $350 million):

    • Senior debt holders are paid in full, i.e., $100 million.
    • Junior debt holders are paid in full, i.e., $100 million.
    • Remaining cash flow to equity holders = 350100100=150350 - 100 - 100 = 150 million.

Step 3: Expected cash flow to equity holders

  • Probability of each state is 0.5 (as given).
  • In the bad state, equity holders get 0.
  • In the good state, equity holders get $150 million.
  • The expected cash flow to equity holders is: Expected cash flow to equity=0.5×0+0.5×150=75 million\text{Expected cash flow to equity} = 0.5 \times 0 + 0.5 \times 150 = 75 \text{ million}

Step 4: Determine the new number of shares after buyback

The company is issuing $100 million in junior debt and using it to buy back shares. The current share price is $10, so the number of shares bought back is: Shares bought back=100 million10=10 million shares.\text{Shares bought back} = \frac{100 \text{ million}}{10} = 10 \text{ million shares}. Thus, the new number of shares outstanding is: New shares outstanding=15 million10 million=5 million shares.\text{New shares outstanding} = 15 \text{ million} - 10 \text{ million} = 5 \text{ million shares}.

Step 5: Calculate the new stock price

The total expected cash flow to equity holders is $75 million, and this cash flow is distributed over 5 million shares. Therefore, the new stock price is: New stock price=75 million5 million=15 dollars per share.\text{New stock price} = \frac{75 \text{ million}}{5 \text{ million}} = 15 \text{ dollars per share}.

Conclusion:

The price of the stock per share after the announcement is $15.

Would you like more details on any specific part of the process?

Here are 5 follow-up questions to consider:

  1. How does the bankruptcy cost affect the stockholders' expected cash flow?
  2. What would happen to the stock price if the bankruptcy cost were higher or lower?
  3. How does the issuance of junior debt impact the overall risk profile of the company?
  4. What if the probability of the good state was higher than the bad state? How would that change the stock price?
  5. How does the capital structure of the company (debt vs equity) affect its valuation?

Tip: When issuing debt, always consider the effect on bankruptcy risk and how it could reduce equity value through potential bankruptcy costs.

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Math Problem Analysis

Mathematical Concepts

Expected Cash Flow
Debt and Equity Valuation
Bankruptcy Costs
Stock Buyback

Formulas

Expected cash flow to equity = 0.5 * Cash Flow (Bad State) + 0.5 * Cash Flow (Good State)
Shares bought back = Debt issued / Stock price
New stock price = Expected cash flow to equity / New shares outstanding

Theorems

Modigliani-Miller Theorem (MM World)

Suitable Grade Level

Undergraduate Finance / MBA Level