Question

Pearson, Inc. is 100% equity financing and has an expected perpetual EBIT of $380,000. The firm's cost equity is 11%. The firm is considering issuing $1, 200,000 in new par bonds to financial leverage to the firm. The proceeds of the debt will be used to repurchase equity. The cost of debt is s% and the tax rate is 30 percent

(a) What is the value of the firm under current capital structure of 100% equity financing?

(b) What will the value be if Pearson, Inc. borrows $1, 200,000 and uses the proceeds to repurchase shares?

(c) What is the cost of equity after recapitalization?

(d) What is the weighted average cost of capital (WACC) after recapitalization?

Answer 1

a) Value of firm under current capital structure of 100% equity financing = EBIT (1-tax rate) / Cost of equity

= 380000(1-30%) / 11%

= 380000 (0.7) /11%

= 266000 /11%

= 2418181.82 $

b) Value of firm if Pearson, Inc. borrows $1,200,000 = Value of unlevered firm + (Debt x tax rate)

= 2418181.82 + (1200000 x 30%)

= 2418181.82 + 360000

= 2778181.82 $

c) Value of equity after borrowing = Value of levered firm - debt

= 2778181.82 - 1200000

= 1578181.82

Cost of equity after recapitalization = Cost of unlevered equity + (Cost of unlevered equity - rate of interest) x (D/E) x (1-tax rate)

= 11% + (11%-5%) x 1200000 / 1578181.82 x (1-30%)

= 11% + (6% x 0.7604 x 0.7)

= 11% + 3.19%

= 14.19%

d) WACC after recapitalization = Cost of equity after recapitalization x (Equity/Debt + equity) + Interest rate(1-tax rate) x (Debt/Debt + equity)

= 14.19% x (1578181.82/2778181.82) + 5%(1-30%) x (1200000/2778181.82)

= [14.19% x 0.5681] + [5%(0.7) x 0.4319]

= 8.06% + 3.5% x 0.4319

= 8.06% + 1.51%

= 9.57%