A company has an EBIT of $4,635 in perpetuity. The unlevered cost of capital is 16.22%,...

A company has an EBIT of $4,635 in perpetuity. The unlevered cost of capital is 16.22%, and there are 26,490 common shares outstanding. The company is considering issuing $10,160 in new bonds at par to add financial leverage. The proceeds of the debt issue will be used to repurchase equity. The YTM of the new debt is 11.29% and the tax rate is 34%. What is the cost of the levered equity after the restructuring?

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Expert Solution

Value of Unlevered Firm = EBIT * (1 - Tax Rate) / Unlevered Cost of Equity
Value of Unlevered Firm = $4,635 * (1 - 0.34) / 0.1622
Value of Unlevered Firm = $3,059.10 / 0.1622
Value of Unlevered Firm = $18,860.05

Value of Levered Firm = Value of Unlevered Firm + Tax Rate * Value of Debt
Value of Levered Firm = $18,860.05 + 0.34 * $10,160
Value of Levered Firm = $22,314.45

Value of Equity = Value of Levered Firm - Value of Debt
Value of Equity = $22,314.45 - $10,160.00
Value of Equity = $12,154.45

Debt-Equity Ratio = Value of Debt / Value of Equity
Debt-Equity Ratio = $10,160.00 / $12,154.45
Debt-Equity Ratio = 0.83591

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 = 0.1622 + (0.1622 - 0.1129) * (1 - 0.34) * 0.83591
Levered Cost of Equity = 0.1622 + 0.0272
Levered Cost of Equity = 0.1894 or 18.94%

ekkarill92 answered 1 year ago

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