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The following data is obtained from the financial statements of Hercules Tractors Limited: EBIT = $4.5...

The following data is obtained from the financial statements of Hercules Tractors Limited: EBIT = $4.5 million; tax rate = T = 40%; debt outstanding = D = $4 million; rd = 12%; rs = 16%; shares of stock outstanding = N0 = 750,000; and book value per share = $21. Because company's product market is stable and the company expects no growth, all earnings are paid out all dividends. The debt consists of perpetual bonds.

(a) What are Hercules' earnings per share (EPS) and its price per share (P0)?

(b) What is Hercules' weighted average cost of capital (WACC)?

(c) Hercules can increase its debt by $10 million, to a total of $14 million, using the new debt to buy back and retire some of its shares at the current price. Its interest rate on debt will be 15 percent (it will have to call and refund the old debt), and its cost of equity will rise from 16 to 18 percent. EBIT will remain constant. Should the company change its capital structure?

Expert Solution

A	Earnings before Interest and Tax	4,500,000
B	Interest @ 12 % on 4 Mill	480,000
C = A-B	Profit Before Tax	4,020,000
D	Tax @ 40%	1,608,000
E = C - D	Profit after Tax	2,412,000
F = E	Earnings avalable to Equity Share Holders	2,412,000
G	No of Shares	750,000
H	Earings per share	3.22

In the question it is mentioned there is no growth and same divident will be paid next year.

P0 = D1/Ke-g

P0= 3.22/0.16-0

P0= 20.125

Part b)

Book Value per share = Share holders Equity+Reserves / Total no of shares

21 = Share Holders Equity + 0/750000

Share holders Equity in Value = 15750000

Debt in value = 4000000

	Amount	Proportion	Cost of Capital	WACC
Debt	4,000,000	0.20	0.072	0.01
Equity	15,750,000	0.80	0.16	0.13
	19,750,000			0.14

After tax cost of debt is used in above debt cost. Hercules WACC is 14%

Part c)

Number of shares that can be bought at current price = 10000000/20.125

= 496894 Shares

Remaining Shares = 253106 shares

Debt has increased to 14000000 at after tax cost of capital of 0.09 %

Remaing Value of Equity = 15750000 - 10000000 = 5750000

	Amount	Proportion	Cost of Capital	WACC
Debt	14,000,000	0.71	0.09	0.06
Equity	5,750,000	0.29	0.18	0.05
	19,750,000			0.12

The revised WAAC is 12% with new capital structure

The value of the share after change in capital structure is = 5750000/253106

= 22.72

Infusing debt in to capital structure is resulting in increas of share price hence adviced to change.

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