Question

Question 1 –Cost of Capital in Perfect MarketsCurrently, ABCCorp. has as market capitalization of $400 million and a market value of debt of $150 million. The current cost of equity for ABC Corp. is 12% and its current cost of debt is 5%. Assume perfect capital markets (no taxes, no market frictions).You are trying to assess how different transaction would affect the cost of equity.

A)Suppose ABC issues$150 million of new equity and buys back the debtit currently has outstanding. What is ABC’scost of equity after this transaction?

B)Suppose ABC issuesan additional $150 million of new debt and pays its shareholders a dividend(so total debt after this transaction is $300mn). Assuming its cost of debt remains at 5%, what is ABC’scost of equity after this transaction?

Answer 1

a). rsL = 12% (cost of levered equity); rd = 5% (cost of debt)

If the firm buys back the entire debt, then it becomes an unlevered firm so cost of equity after the transaction will be the cost of levered equity rsU.

rsU = weight of debt*cost of debt + weight of equity*cost of equity

= (150/(400+150))*5% + (400/(400+150))*12% = 10.09%

b). New D/E = 300/400 = 0.75

Cost of equity = rsU + (rsU-rd)*D/E

= 10.09% + (10.09%-5%)*0.75 = 13.91%