Question

1. Smith’s HVAC currently has EBIT of $65,000 and is a zero growth company. It has $150,000 (book value) of perpetual debt outstanding carrying a coupon rate of 7% and a current market price of 101.2. Smith's current cost of equity is 9.3%, and its tax rate is 21%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. (Hint: Do not worry about calculating unlevered beta for this problem.)

a. What is Smith's current total market value and weighted average cost of capital?

b. The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 8.2%, while the required rate of return on equity would rise to 9.7%. If this plan were carried out, what would be Smith's new WACC and total value?

c. Now assume that Smith is considering changing from its original capital structure to a new capital structure that results in a stock price of $62 per share. The resulting capital structure would have a $336,000 total market value of equity and a $504,000 market value of debt. How many shares would Smith repurchase in the recapitalization? (Round to the nearest whole share.)

d. Now assume that Smith is considering changing from its original capital structure to a new capital structure with 60% debt and 40% equity. If it makes this change, its resulting market value would be $720,000. What would be its new stock price per share?

Answer 1

Smith HVAC
			EBIT	65000	$
			Growth	0%
			Shares	10,000
			Price per share	60	$
			Value of Equity	6,00,000	$
			Cost of Equity	9.30%
			Book Value of Debt	150000	$
			Coupon	7%
			Current market Price	101.2	$
			Market Value of Debt	151800	$
			YTM for perpetual debt	6.9%	Cost of Debt
			Tax Rate	21%
Part A
			Proportion of Debt / Capital	20%
			Proportion of Equity / Capital	80%
			Cost of Debt	6.9%
			Cost of Equity	9.30%
			Tax Rate	21%
			WACC	8.5%
			Total Market Value	7,51,800	$

WACC Formula used = D/(D+E)*rd*(1-T)+re*E/(D+E)*re

Part B

Part B			Proportion of Debt / Capital	40%
			Proportion of Equity / Capital	60%
							EBIT	65000
			--> New Debt total	3,00,720			-Interest	10500
			New Equity Total	4,51,080			EBT	54500
			Rd	8.20%			Tax	11445
			Re	9.70%			FCFE	43055
			Tax Rate	21%			FCFF	53555
			WACC	8.411200%
			Total Market Value	6,36,711	FCFF/WACC

PART C			Stock Price	62
			Market Value of Equity	336000
			Market Value of Debt	504000
			No. of Shares as per new price and value	5419
			Old no. of shares	10,000
			No. of shares bought in repurchase	4,581

PART D			Proportion of Debt / Capital	60%
			Proportion of Equity / Capital	40%
			Total Value	720000
			Value of Equity	288000	40%
			Value of Debt	432000	60%
			New Debt brought in	280200
			Value of Equity Repurchased	280200
			Total Value of Equity Before repurchase	568200
			No. of Equity Shares before debt	10000
			Price per share	56.82