Question

SOS Ltd is currently an all-equity firm and has a market value of $800,000. SOS is evaluating whether a levered capital structure would maximize the wealth of shareholders. The cost of equity is currently 15%. The new capital structure under consideration is an issue of $400,000 new perpetual debt with an 8% interest rate. There are currently 32,000 shares outstanding and a tax rate of 35% applies to this firm. If SOS finally changes to the new levered capital structure,

(a) Calculate the present value of tax shield and explain it briefly. (Show your calculations).

(b) Calculate the firm value and the cost of equity under the levered capital structure. Explain the change in cost of equity briefly. (Show your calculations).

(c) Calculate the WACC under the levered capital structure. (Show your calculations).

(d) What are the stock prices of SOS before and after announcement of the new capital structure? Explain the price change briefly. (Show your calculations).

(e) Suppose the actual stock price of SOS after announcement of the new capital structure is lower than your answer in part (d) above, what could be the possible reasons for this?

Answer 1

ii) It is Clearly visible that Stock price increase from 25 to 33.17 it is due to the fact that we are generating same percentage of return/ Cash Flow i.e 15% by deploying further capital at a much lower interest rate of 8%. This 8% further reduced by Interest Tax shield to 5.2%. Hence cost of capital i.e WACC is quite lower and all the benefit gone to equity shareholder

iii) Few Reasons are

1. We are assuming same FCFF as a % of Capital Employed which is not true when there is a lack of further Investment Opportunity.
2. Distress Cost associated with Debt which might Hindered Asset quality and create a Liquidity/Solvency Issues in a Company.
3. Shareholder have a Residual interest in Company after payment to Debtholder which might Increase Shareholder risk

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