Your firm is operating in a world where the only imperfection is that corporations must pay...

Your firm is operating in a world where the only imperfection is that corporations must pay tax. The company is currently all equity financed. Your company has 2,900,000 shares outstanding. Your firm expects to generate earnings before interest and taxes of $3,450,000 per year in perpetuity. The company is planning on borrowing $9,000,000 and using the proceeds of the loan to repurchase some of its outstanding shares. The unlevered cost of equity is 11.20%. The company's cost of debt before taxes is 5.60%. The tax rate is 35.00%.

What will be the required rate of return on the equity after the recapitalization (borrow the money and repurchase shares) is completed?

Solutions

Expert Solution

Value of Unlevered Firm = EBIT * (1 - Tax Rate) / Unlevered Cost of Equity
Value of Unlevered Firm = $3,450,000 * (1 - 0.35) / 0.1120
Value of Unlevered Firm = $2,242,500 / 0.1120
Value of Unlevered Firm = $20,022,321.43

Value of Levered Firm = Value of Unlevered Firm + Tax Rate * Value of Debt
Value of Levered Firm = $20,022,321.43 + 0.35 * $9,000,000
Value of Levered Firm = $23,172,321.43

Value of Equity = Value of Levered Firm - Value of Debt
Value of Equity = $23,172,321.43 - $9,000,000
Value of Equity = $14,172,321.43

Debt-Equity Ratio = Value of Debt / Value of Equity
Debt-Equity Ratio = $9,000,000 / $14,172,321.43
Debt-Equity Ratio = 0.6350

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.1120 + (0.1120 - 0.0560) * (1 - 0.35) * 0.6350
Levered Cost of Equity = 0.1120 + 0.0231
Levered Cost of Equity = 0.1351 or 13.51%

Therefore, the required rate of return on the equity after the recapitalization is 13.51%

jeff jeffy answered 1 year ago

Next > < Previous

Related Solutions

You are in a world where there are only two assets, gold and stocks. You are...

You are in a world where there are only two assets, gold and stocks. You are interested in investing your money in one, the other, or both assets. Consequently, you collect the following data on the returns on the two assets over the past six years. Gold Stock Market Average return 8% 20% Standard deviation 25% 22% Correlation -0.4 Compute the expected return and standard deviation of a portfolio consisting of 0% stocks 25% stocks 50% stocks...

There are two countries, England and USA, in a world where there are only two factors...

There are two countries, England and USA, in a world where there are only two factors of production, land and labor. England has 8 million acres of land and 2 million workers while USA has 5 million acres of land and 1 million workers. Both countries produce two goods, cars and watches, using identical technology. Per acre of land, the production of cars requires 4 workers while the production of watches requires 1 worker. Using a PPF/indifference curve graph, illustrate...

Consider you are a Chief Manager of a firm that is operating in a market where...

Consider you are a Chief Manager of a firm that is operating in a market where any firm can enter or exit without any barrier. At present, your competitors are in crises and your firm too is facing losses. But you firmly decided to remain in the market and not to shut-down your business. Explain the what economic rule constitute for your decision ‘not to shut-down’. Also explain how you would overcome the short-run losses in long-run, and what kinds...

You are in a world where there are only two assets, gold and U.S. stocks. You...

You are in a world where there are only two assets, gold and U.S. stocks. You are interested in investing your money in one, the other, or both assets. Consequently, you collect the following data on the returns on the two assets over the last six years. Gold Stock market Average return 8% 20% Standard deviation 25% 22% Correlation - 0.4 1. If you were constrained to pick just one, which one would you choose? Explain. (2) A friend argues...

Q7. Ivy lives in a world where there are only two goods, X and Y. Her...

Q7. Ivy lives in a world where there are only two goods, X and Y. Her utility function per period is given by: U = 30x – 0.5x2 + 40y - y2 (c) Show that at the point of utility-maximization in (b) the ratio of marginal utility of the two goods equals their price ratio. (d) Provide a one-sentence interpretation for the value of the Lagrangian multiplier obtained in (b). (e) At what income level is Ivy’s utility of money...

In your opinion, do corporations now pay their fai share of taxes? Explain why or why...

In your opinion, do corporations now pay their fai share of taxes? Explain why or why not. If not, what should be done about it?

In your opinion, do corporations now pay their fai share of taxes? Explain why or why...

In your opinion, do corporations now pay their fai share of taxes? Explain why or why not. If not, what should be done about it?

if a profit maximizing firm facing a linear demand curve is operating where |?| = 1,...

if a profit maximizing firm facing a linear demand curve is operating where |?| = 1, i.e. the unit elastic portion of the demand curve, what must marginal cost be? Draw this on a graph (recall from your answer to #1 that MR is twice as steeply sloped as demand). ( 2 pts)

Semi-Salt Industries began its operation in 1975 and remains the only firm in the world that...

Semi-Salt Industries began its operation in 1975 and remains the only firm in the world that produces and sells commercial-grade polyglutamate. While virtually anyone with a degree in college chemistry could replicate the firm’s formula, due to the relatively high cost, Semi-Salt has decided not to apply for a patent. Despite the absence of patent protection, Semi-Salt has averaged accounting profits of 5.5 percent on investment since it began producing polyglutamate—a rate comparable to the average rate of interest that...

Discuss Briefly: (a) The more debt a firm issues, the higher interest rate it must pay;...

Discuss Briefly: (a) The more debt a firm issues, the higher interest rate it must pay; thus firms should operate at conservative debt levels. (b) Given the choice between two investment projects with the same systematic risk and the same expected return, all bondholders would prefer the project with the lower variance and all stockholders would prefer the project with the higher variance. (c) Black-Sholes is inappropriate for valuing a levered firm’s equity, the empirical evidence indicates that higher interest...

Subjects