Question

Baxter has historically maintained a debt-equity ratio of approximately 0.25. The firm enjoys very stable demand for its products, and consequently can borrow at 4.20%, just 20 basis points over the risk-free rate of 4%. Baxter’s tax rate is 40%. Baxter’s current return on equity (rE) is 8%

Baxter believes it can increase debt without any serious risk of distress or other costs. With a higher debt-equity ratio of 0.50, it believes its borrowing costs will rise only slightly to 4.50%.

a) Determine Baxter’s rA and rWACC before the recapitalization

b) If Baxter announces that it will raise its debt-equity ratio to 0.5 through a leveraged recapitalization, determine its new WACC

c) Baxter is expected to have free cash flows of $10 billion in perpetuity. Determine the increase in the company value that would result from the anticipated tax savings.

Answer 1

	a)	rA andrWACC before recapitalization
		Debt/Equity=0.25
		Debt=0.25Equity
		Total Capital =Equity +0.25 Equity=1.25 Equity
		Weight of Equity =1/1.25=	0.8
		Weight of Debt =0.25/1.25=	0.2
		rA=After tax Cost of debt =4.2*(1-0.4)=	2.52%
		rWACC=Weighted Average Cost of Capital
		rWACC=Weight of Equity*Cost of equity+Weight of Debt*Cost of Debt
		rWACC=0.8*8%+0.2*2.52%=	6.90%
	b)	If Debt Equity ratio is raised to 0.5
		Debt=0.5Equity
		Total Capital =Equity +0.5 Equity=1.5 Equity
		Weight of Equity =1/1.5=	0.666666667
		Weight of Debt =0.5/1.5=	0.333333333
		rA=After tax Cost of debt =4.5*(1-0.4)=	2.70%
		rWACC=Weighted Average Cost of Capital
		rWACC=Weight of Equity*Cost of equity+Weight of Debt*Cost of Debt
		rWACC=0.666667*8%+0.333333*2.7%=	6.23%
	c)	Annual Free Cash Flow in perpetuity	$10	billion
		Company Value before recapitalization	$144.84	billion	(10/0.0690)
		Company Value AFTER recapitalization	$160.43	billion	(10.0.0623)
		Increase in Company Value=160-43-144.84=	$15.58	billion