Question

A particular company has no debt outstanding, total assets of $8,000,000 (book value=market value), EBIT of $1,600,000, and a cost of equity of 14%. The price of the company’s stock is $20 per share, the number of shares outstanding is 400,000, and the tax rate for the company is 40%. In an adjustment to its capital structure, the company is considering selling bonds and simultaneously repurchasing some of its stock. If the company moves to a capital structure with 40% debt based on market values, its cost of equity will increase to 16% in order to reflect the increased risk. Bonds can be sold at a cost of 6%. The company is a no-growth firm, i.e., all its earnings are paid out as dividends, and earnings are expected to be constant.

A.) What is the weighted average cost of capital change if the company goes from no debt to a capital structure with 40% debt?

B.) What effect would this use of leverage have on the value of the company?

C.) What would be the price of the company’s stock?

Answer 1

• As it is given that market value of the firm ie equal to the book value. Therefore, amount of Debt to be issued by the company = 8,000,000 * 40%

= $3,200000

• Calculation of WACC :

Given :

Cost of Equity after introducing debt (Ke) = 16%

Weight of Equity = 60%

Weight of Debt (Kd) = 40%

Cost of Debt = 6%

Tax Rate = 40%

Therefore,

WACC = (Weight of Equity * Ke) + {Weight of Debt * Kd * (1-tax rate)}

WACC = (0.6 * 16) + {0.4 * 6 * (1-0.4)}

WACC = 9.6 + { 1.44 }

WACC = 11.04 %

• Value of the company after introducing debt using free cash flow to the firm approach :

Given :

EBIT = $1,600,000

Earning After Tax (EAT) = 1,600,000 - (1,600,000*0.4)

= 1,600,000 - 640,000

= $ 960,000

Therefore, Value of the company using Free Cash Flow to Firm :

= EAT / WACC

= 960000 / 0.1104

= $8,695,652

Conclusion : Because of leverage the value of the firm increases by (8695652 - 8000000) $695,652.

• Calculation of the price of the company's stock :

1. Number of shares buyback by the company by issuing debt :

= Amount of Debt issued / Market price of the stock

= 3200000 / 20 = 160000 shares

2. Number shares outstanding = 400000 shares - 160000 shares

= 240,000 shares.

3. Market value of equity = Value of the firm - Value of the debt

= $8,695,652 - $3200000

= $5,495,652

Therefore,

• Price per share = Market Value of Equity / Number of shares outstanding

= 5495652 / 240000

= $22.90