Question

Boston Cube Inc. currently has no debt, annual free cash flows of $74 million and an average tax rate of 34%. Free cash flows are expected to grow by 5% per year forever.

Using the CAPM, the firm estimates that its cost of equity is 12%. The risk-free rate is 2% and the expected equity market risk premium (MRP) is 7%. There are 8 million shares outstanding.

The firm is considering a new capital structure with a debt-to-capital ratio of 20%. The company would issue bonds to repurchase its own shares at the market price. An investment bank has estimated that the yield to maturity on the company's bonds would be 3%.

stock price before the recapitalization is 138.75

Part 2: What will be the WACC after the recapitalization?

Part 3: What will be the stock price after the recapitalization and how many shares will be outstanding at that price?

Answer 1

Answer to Part 2:

WACC = Cost of Equity x weight of equity + Cost of debt x weight of debt

Cost of Equity = 12 %

Weight of Equity = 80%

Cost of debt (post tax) = 3% (1-0.34) = 1.98%

Weight of Debt = 20%

WACC = 12 * 80% +1.98 * 20% = 10%

Answer to Part 3:

Assuming price of 1 share = 100, SO total book value of Equity = 800 million

will no be reduced to 80% = 800*80 % = 640 million

Let the amount to debt issued be x

so, 640 = {(8x138.75 ) - x / 138.75} * 100

x = 222 million

Therefore shares bought back = 222/138.75 =1.6 million shares.

The price of the share post Buyback remains the same