Question

Spam Corp. is financed entirely by common stock and has a beta of .75. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price-earnings ratio of 7.80 and a cost of equity of 12.82%. The company’s stock is selling for $54. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with an interest rate of 3.5%. The company is exempt from corporate income taxes. Assume MM are correct.

1. Calculate the cost of equity after the refinancing. (Enter your answer as a percent rounded to 2 decimal places.)
2. Calculate the overall cost of capital (WACC) after the refinancing. (Enter your answer as a percent rounded to 2 decimal places.)
3. Calculate the price-earnings ratio after the refinancing. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
4. Calculate the stock price after the refinancing.
5. Calculate the stock’s beta after the refinancing. (Round your answer to 1 decimal place.)

Answer 1

SOLUTION:

BETA=0.75

P/E RATIO=7.80

COST OF EQUITY(Ke)=12.82%

Selling price of stock $54

Debt interest rate=3.5%

According to MM Approach

A)Cost of equity after refinancing

After repurchase the companu has 50% debt and 50% equity.So

Ke=Ke+debt/equity(Ke-Kd)

=12.82+0.5/0.5(12.82-3.5)

=12.82+9.32

=22.14%

B)Overall cost of capital (WACC) after the refinancing

According to MM Approach , WACC is same as before due to perfect capital markets.So,

Ko=Ke*We+Kd*Wd

=22.14*0.50+3.5*0.50

=12.82%

C)Profit earning ratio after refinancing

Suppose THE company has 1000 shares so there market value is 1000*54=$54000 and after refinancing,debt is 27000 and equity is 27000(half)

so,Earning per share=selling price/pe ratio=54/7.8= 6.92

So, Net income=1000*6.92=$6920

Less:Interest on debt

(27000*3.5%) (945)

Earning $5975

No of shares after refinancing =500 shares(1000/2)

Earning per share after refinancing=5975/500=$11.95

Market price per share =$54

P/E Ratio=Market price per share/earning per share

54/11.95=4.51

D)Stock price after refinancing:

MARKET PER SHARE=P/E RATIO*EARNING PER SHARE

=4.51*11.95= $53.89

E)Stock beta after refinancing

STOCK BETA=[(Ke-Kd)]/[WACC-Kd)

=(22.14-3.5)/(12.82-3.5)

=18.64/9.32=2