Question

In: Finance

Ponion Boy Inc. (PB) has a total market value of $400 million, consisting of 12 million...

Ponion Boy Inc. (PB) has a total market value of $400 million, consisting of 12 million shares of common stock selling for $25 per share and $100 million of 8 percent perpetual bonds currently selling at par. PB pays out all earnings as dividends, and its marginal tax rate is 35 percent. The firm’s earnings before interest and taxes (EBIT) are $45 million. Management is considering increasing PB’s debt until its capital structure has 65 percent debt, based on market values. The additional funds will be used to repurchase stock at the new equilibrium price. At the new capital structure, PB’s cost of debt is estimated at 13.5 percent and its cost of equity is estimated to be 14.85 percent.

What is PB’s weighted average cost of capital at its current debt level of $100 million?

      a. 7.32%      

      b. 9.51%      

      c. 10.52%     

      d. 8.75%      

      e. 12.25%

What is PB’s weighted average cost of capital at its new capital structure?

      a. 8.25%      

      b. 8.553%     

      c. 9.89%      

      d. 9.25%      

      e. 10.90%

Based on the WACC calculated in Problem 6, what is the new total corporate value of PB?

      a. $190,209,133

      b. $198,087,774

      c. $268,348,623

      d. $220,570,098

Based on the UBI’s new total corporate value calculated in 7, what is the value of the debt that PB has in its new capital structure?

      a. $86,359,128.26

      b. $99,321,167.25

      c. $118,852,664.85

      d. $138,439,097.50

      e. $174,426,605.50

Based on PBs new total corporate value in problem 7 and its new value of debt in problem 8, how many shares remain outstanding after the recapitalization?

      a. 1,215,400 shares      

      b. 1,200,000 shares      

      c. 1,872,341 shares      

      d. 9,320,451 shares      

      e. 6,694,371 shares`

Solutions

Expert Solution

Weighted Average Cost of Capital = Cost of Debt (after tax)*Weight of Debt + Cost of Equity* Weight of equity

EBIT 45,000,000
Less Interest 8,000,000
EBT 37,000,000
Less Tax 12,950,000
Earnings after Tax (EAT) 24,050,000

1. Before recapitalisation,

Cost of Debt (after tax) = 8*(1-0.35) = 5.20%

Cost of Equity = EAT/Value of Equity = 24,050,000/300,000,000 = 8.02%

Weight of Equity = 300,000,000/400,000,000 = 0.75

Weight of Debt = 100,000,000/400,000,000 = 0.25

WACC = 0.75*8.02 + 0.25*5.20 = 7.31%

The answer is (a)

2. After capitalisation,

Cost of debt (after tax)= 13.5(1-0.35) = 8.78%

Cost of equity = 14.85%

Weight of debt = 0.65

Weight of equity = 0.35

WACC = 0.65*8.78 + 0.35*14.85 = 10.90%

The answer is (e)

3. Value of company = Free Operating Cash Flow/WACC

Free Operating Cash Flow = 45,000,000*(1-0.35) (where 0.35 is the tax rate)

= 29,250,000

Value of company = 29,250,000/0.1090 = 268,317,853

This value is approximately equal to 268,348,623

The answer is (c)

4. Value of Debt = 65% of 268,348,623 = 174,426,604.95

Thus, the answer is approximately equal to (e)


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