Cede & Co. expects its EBIT to be $65,000 every year forever. The firm can borrow...

Cede & Co. expects its EBIT to be $65,000 every year forever. The firm can borrow at 9 percent. The firm currently has no debt, its cost of equity is 15 percent, and the tax rate is 35 percent. Assume the firm borrows $173,000 and uses the proceeds to repurchase shares.

What is the cost of equity after recapitalization? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

1) Cost of equity?

What is the WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

2) WACC?

Expert Solution

Value of Unlevered Firm = EBIT * (1 - Tax Rate) / Unlevered Cost of Equity
Value of Unlevered Firm = $65,000 * (1 - 0.35) / 0.15
Value of Unlevered Firm = $281,666.67

Value of Levered Firm = Value of Unlevered Firm + Value of Debt * Tax Rate
Value of Levered Firm = $281,666.67 + $173,000 * 0.35
Value of Levered Firm = $342,216.67

Value of Equity = Value of Levered Firm - Value of Debt
Value of Equity = $342,216.67 - $173,000
Value of Equity = $169,216.67

Weight of Debt = Value of Debt / Value of Levered Firm
Weight of Debt = $173,000 / $342,216.67
Weight of Debt = 0.50553

Weight of Equity = Value of Equity / Value of Levered Firm
Weight of Equity = $169,216.67 / $342,216.67
Weight of Equity = 0.49447

Debt-Equity Ratio = Weight of Debt / Weight of Equity
Debt-Equity Ratio = 0.50553 / 0.49447
Debt-Equity Ratio = 1.0224

Answer 1.

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.15 + (0.15 - 0.09) * (1 - 0.35) * 1.0224
Levered Cost of Equity = 0.15 + 0.0399
Levered Cost of Equity = 0.1899 or 18.99%

Answer 2.

WACC = Weight of Debt * Cost of Debt * (1 - Tax Rate) + Weight of Equity * Levered Cost of Equity
WACC = 0.50553 * 9.00% * (1 - 0.35) + 0.49447 * 18.99%
WACC = 12.35%

jeff jeffy answered 2 days ago

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