Question

Pettit Printing Company (PPC) has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company's EBIT is $10.00 million, and its tax rate is 15%. Pettit can change its capital structure by either increasing its debt to 55% (based on market values) or decreasing it to 45%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with an 11% coupon. If it decides to decrease its leverage, it will call its old bonds and replace them with new 9% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change.

PPC expects no growth in its EBIT, so g_L is zero. Its current cost of equity, r_s, is 14%. If it increases leverage, r_s will be 16%. If it decreases leverage, r_s will be 13%. What is the firm's WACC and total corporate value under each capital structure? Do not round intermediate calculations. Enter your monetary answers in millions. For example, an answer of $1.234 million should be entered as 1.234, not 1,234,000. Round your answers to three decimal places.

	50% debt	55% debt	45% debt
WACC	____%	____%	____ %
Total corporate value	$ __ million	$ __ million	$ __ million

Answer 1

Total Market value = $100 million

EBIT = $10 million

Tax rate , t = 15%

There are 3 scenarios

Scenario	Weight of Equity (We)	Weight of Debt (Wd)	Cost of Equity (Ke)	Cost of Debt (Kd)
Current	50%	50%	14%	10%
When debt is more	45%	55%	16%	11%
When debt is less	55%	45%	13%	9%

1) Current scenario

WACC = Wd * Kd * (1-t) + We * Ke

WACC = [0.50 * 0.10 * (1- 0.15)] + [0.50 * 0.14]

= 0.0425 + 0.07

= 0.1125 or 11.25%

Corporate Value = Net operating income / WACC

= EBIT (1-T) / WACC

= $10 (1-0.15) / 0.1125

= $75.55 million

2) When Debt is more

WACC = Wd * Kd * (1-t) + We * Ke

WACC = [0.55 * 0.11 * (1- 0.15)] + [0.45 * 0.16]

= 0.051425+ 0.072

= 0.1234 or 12.34%

Corporate Value = Net operating income / WACC

= EBIT (1-T) / WACC

= $10 (1-0.15) / 0.1234

= $68.88 million

3) When debt is less

WACC = Wd * Kd * (1-t) + We * Ke

WACC = [0.45 * 0.09 * (1- 0.15)] + [0.55 * 0.13]

= 0.034425 + 0.0715

= 0.105925 or 10.59%

Corporate Value = Net operating income / WACC

= EBIT (1-T) / WACC

= $10 (1-0.15) / 0.105925

= $80.24 million