Question

Mercer Corp. has 10 million shares outstanding and ​$147 million worth of debt outstanding. Its current share price is $63. ​Mercer's equity cost of capital is 8.5%. Mercer has just announced that it will issue ​$300 million worth of debt. It will use the proceeds from this debt to pay off its existing​ debt, and use the remaining ​$153 million to pay an immediate dividend. Assume perfect capital markets.

a. Estimate​ Mercer's share price just after the recapitalization is​ announced, but before the transaction occurs.

b. Estimate​ Mercer's share price at the conclusion of the transaction. ​(Hint​: Use the market value balance​ sheet.)

c. Suppose​ Mercer's existing debt was​ risk-free with a 4.64% expected​ return, and its new debt is risky with a 5.03%expected return. Estimate​ Mercer's equity cost of capital after the transaction.

Answer 1

Current Scenario -

Value of equity = 10 million * $63 = $630 million
Value of debt = $147 million
Total Value of the firm = $630 + $147 = $777 million
Cost of Equity = 8.5%

Part 1 -
As it is a perfect capital market, capital structure will have no bearing on the value of the market. Share price after the announcement will remain at $63.

Part 2 -
After the additional debt is raised and old debt repaid, and dividend has been paid
Debt = $300 million
Equity = $777 - $300 = $477 million
No. of shares outstanding are still 10 million.
Share Price = 477/10 = $47.7

Part 3 -
Old cost of debt = 4.64%
New Cost of Debt = 5.03%
Old Cost of Equity = 8.5%
New Cost of Equity = ??

Now remember capital structure doesnt affect the value of firm, so WACC will remain same.
Old Capital Structure --> WACC = (630/777)*8.5% + (147/777)*4.64% = 7.77%
New Capital Structure --> 7.77% = (477/777)*ke + (300/777)*5.03%
Hence Ke = 9.49%

New Cost of capital is 9.49%