Question

2. You are the new financial analyst of the company ABC. Sales of ABC were $2,200,000 last year, variable costs were 50% of sales, and fixed costs were $220,000. Therefore, EBIT totaled $880,000. The EBIT is expected to be constant over time. Because no expansion capital is required, ABC pays out all earnings as dividends. Assets are $4 million, and 200,000 shares are outstanding. ABC currently has no debt it is an all equity firm and its 200,000 shares outstanding sell at a price of $20 per share, which is also the book value. The firm’s federal-plus-state tax rate is 40%. On the basis of statements made in your finance text, you believe that ABC’s shareholders would be better off if some debt financing was used. In today’s market, the risk-free rate, rRF, is 6% and the market risk premium, MRP, is 7%. ABC’s unlevered beta, bU, is 1.2. ABC currently has no debt, so its cost of equity (and WACC) is 13.2%. If the firm was recapitalized, debt would be issued and the borrowed funds would be used to repurchase stock. You were able to obtain the following estimates of the cost of debt at different debt levels

Amount Borrowed D/A Ratio D/E Ratio rd 500,000 0.125 0.1429 7.00% 1,000,000 0.25 0.3333 8.50% 1,500,000 0.375 0.6 11.50% 2,000,000 0.5 1 13.00%

(1) Assume that shares could be repurchased at the current market price of $20 per share. How many shares would remain after recapitalization under each scenario?

(2) Using the Hamada equation, what is the cost of equity if ABC recapitalizes with different levels of debt?

(3) What is the optimal level capital structure?

(4) What is the WACC at the optimal capital structure? Fill in the table and indicate the optimal capital level

Answer 1

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