In: Finance
Isabella Construction and Interior Design is an all-equity
company in Central Michigan. The CFO John Thornton Jr. is
considering moving to a capital structure with 25% debt and 75%
equity and using the all the newly raised capital to
repurchaseshares of the common stock. The firm’s tax rate is 22%,
its current beta is 1.40, and it has 25,000 shares of common stock
with a market price of $312 per share. Assume MM propositions
hold.
a. How many shares of common stock will remain after the
repurchase?
b. If the risk-free rate is 3.5% and the market risk premium is
8.0%, by how much would the cost of equity for the levered firm
increase, compared to the cost of equity of the unlevered
firm?
c. What will be the change in the WACC, if the company can borrow
at 7.25 percent?
Answer a:
Given, target Debt to Capital is 25%
Since, the share repurchase will happen at prevailing market price, the number of shares repurchased by debt will be 25% of total equity shares = 25% of 25,000 = 6,250 shares (as the Capital was all-equity funded initially)
So, number of shares of common stock that will remain after the repurchase = 25,000 - 6,250 = 18,750 shares.
Answer b:
Given, unlevered beta
U = 1.40
Original Cost of Equity = Risk-free rate +
U * Market risk premium = 3.5% + 1.4 * 8% = 14.70% ...(A)
Let, Levered beta be denoted by
L, then
L
=
U * [ 1 + (1 - T) * (D/E) ]
=>
L = 1.40 * [ 1 + (1 - 22%) * (25% / 75%) ] = 1.764
New Cost of Equity = Risk-free rate +
L * Market risk premium = 3.5% + 1.764 * 8% = 17.612% ...(B)
The cost of equity for the levered firm as compared to the unlevered firm will increase by (B - A) = 17.612% - 14.700% = 2.912%
Answer c:
Original WACC = Original Cost of Equity = 14.70%
Now, given Cost of Debt = 7.25%
New Cost of Equity = 17.612%, as calculated in answer b.
New WACC = Proportion of Debt * Cost of Debt * (1 - T) + Proportion of Equity * New Cost of Equity
=> New WACC = 25% * 7.25% * (1 - 22%) + 75% * 17.612% = 14.62275%
Change in WACC = New WACC - Original WACC = 14.62275% - 14.70% = -0.07725% = - 0.08% (rounded to two decimal places)