Anatomy of a Recapitalization

•Strasburg should recapitalize, meaning that it should issue enough additional debt to optimize its capital structure, and then use the debt proceeds to repurchase stock. As shown in a previous Figure, a capital structure with 40% debt is optimal. But before tackling the recap, as it is commonly called, let’s consider the sequence of events, starting with the situation before Strasburg issues any additional debt.
•The valuation analysis of Strasburg at a capital structure consisting of 20% debt and 80% equity. These results are repeated in Column 1, along with the shareholder wealth, which consists entirely of $200 million in stock before the repurchase. The next step is to examine the impact of Strasburg’s debt issuance.



•The next step in the recap is to issue debt and announce the firm’s intent to repurchase stock with the newly issued debt. At the optimal capital structure of 40% debt, the value of the firm’s operations is $257.86 million as shown in the Figure above. This value of operations is greater than the $250 million value of operations for wd = 20% because the WACC is lower.
•Notice that Strasburg raised its debt from $50 million to $103.14 million, an increase of $53.14 million. Because Column 2 reports data prior to the repurchase, Strasburg has short-term investments in the amount of $53.14 million, the amount that was raised in the debt issuance but that has not yet been used to repurchase stock. As the chart shows, Strasburg’s intrinsic value of equity is $207.86 million.

•Because Strasburg has not yet repurchased any stock, it still has 10 million shares outstanding. Therefore, the price per share after the debt issue but prior to the repurchase is: 


•Column 2 of the Figure above summarizes these calculations and also shows the wealth of the shareholders. The shareholders own Strasburg’s equity, which is worth $207.86 million. Strasburg has not yet made any cash distributions to shareholders, so the total wealth of shareholders is $207.86 million. The new wealth of $207.86 million is greater than the initial wealth of $200 million, so the recapitalization has added value to Strasburg’s shareholders. Notice also that the recapitalization caused the intrinsic stock price to increase from $20.00 to $20.79.
•Summarizing these results, we see that the issuance of debt and the resulting change in the optimal capital structure caused (1) the WACC to decrease, (2) the value of operations to increase, (3) shareholder wealth to increase, and (4) the stock price to increase.



Last modified: Tuesday, August 14, 2018, 8:55 AM