Question

Firm C currently has 250,000 shares outstanding with current market value of $47.40 per share and generates an annual EBIT of $1,250,000. Firm C also has $1 million of debt outstanding. The current cost of equity is 8 percent and the current cost of debt is 5 percent. The firm is considering issuing another $2 million of debt and using the proceeds of the debt issue to repurchase shares (a pure capital structure change). It is estimated that the cost of the new debt will be 5.5 percent and that the cost of equity will rise to 9 percent with the additional debt. The marginal tax rate is 21 percent.

1.) Before the capitalization, what is the firm's weighted average cost of capital? Answer in decimal form.

2.) What will the firm’s market value be after the announcement of the new debt issue?

3.) What will the estimated new share price be after the capital structure change announcement?

Answer 1

1. The computation of the weighted average cost of capital is shown below:

But before that we need to do the following calculatoions

After tax cost of debt = Cost of debt * (1 - Marginal Tax rate)

= 5% * (1 - 0.21)

= 5% * 0.79

= 3.95 %

Now the total equity is

Value of the equity = Share Price * Total shares outstanding

= $47.40 * 250,000

= $11,850,000

= $11.85 Millions

And, the debt is $1 million

So, the total capital is

= $11.85 million + 1 million

= $12.85 million

As we know that

WACC = (Weight of debt * Post tax-Cost of Debt) + (Weight of equity * Cost of equity)

Weight of debt = Total Debt / Total Capital

= 1 / 12.85

= 0.07

And, Weight of Equity is

= 1- Weight of debt

= 1- 0.07

= 0.93

Now the WACC is

WACC = (0.07 * 3.95%) + (0.93 * 8%)

WACC = 7.71%

2) The computation of the firm market valeu after considering the new debt issue annoucement is

But before that we need to do the following calculations

Given that

EBIT = $1,250,000

Interest Cost = 5% on old debt + 5.5% on new debt

                    = (5% * 1,000,000) + (5.5% * 2,000,000)

                    = $50,00 + $110,000

= $160,000

Now

Net Profit = (EBIT - Interest)* (1-Tax Rate)

              = (1,250,000 - $160,000) * (1 - 0.21)

              = $861,100

Also as we know that

Cost of Equity = Net Profit / Maret Value of equity

So,

Market Value of Equity = Net Profit / Cost of Equity

= 861,100 / 0.09

= $9,567,778

Hence, the new market value of the firm is

= $9,567,778 + $3,000,000

= $12,567,778

3) The estimated new share price is shown below:

But before that first determine the number of oustanding shares

Number of shares that can be buy with $2million is

= $2,000,000 / $47.40

= 42,194 pprox.

Now

Number of Outstanding shares is

= 250,000 - 42,194

= 207,806

And, finally Estimate New Share Price is

= Market Value of Equity / Number of Outstanding Shares

= $9,567,778 / 207,806

= $46.04