Question

For the question' Fan Plc is a publicly traded firm. The market value of its equity is $70 million and its debt $30 million. The yield to maturity of the debt is 5%, the shareholders require a 20% return, and the company pays 30% corporate tax. They have recently decided to repurchase $10 million worth of equity, and finance the repurchase through the issuance of new debt.

1, How will the return on equity be affected by this change?What is the new return on equity of the company?

2,A close conmetitor of Fan Plc has a stock beta of 1.54, when the risk-free rate of return is 4% and the market portfolio offers an expected return of 13%. In addition to equity. the firm finances 40% of its assets with debt that has a yield to maturity of 8%. The firm is the 30% marginal tax bracket. What is this firm's weighted average cost of capital?

Answer 1

1. The weight of debt in firm's capital structure before repurchase = 0.30

The weight of equity in firm's capital structure before repurchase = 0.70

Cost of equity = 20 % (the required return by shareholders)

Cost of debt = Interest of debt (1 - Tax rate) = 5% (1 - 0.30) = 3.5 %

WACC (Weighted average cost of capital) as per existing capital structure = Weight of equity * Cost of equity + Weight of debt * Cost of debt = 0.70 * 20 % + 0.30 * 3.5 % = 14 % + 1.05 % = 15.05 %

Post repurchase the WACC will change in the following manner:

The weight of equity in firm's capital structure after repurchase = 0.70 - 0.10 = 0.60

The weight of debt in firm's capital structure after repurchase = 0.30 + 0.10 = 0.40

New cost of equity = WACC – (Cost of debt* Weight of debt *(1-t))/(Weight of equity) = (0.1505-(0.4*0.05*(1-0.3))/(0.6) = 0.2275 = 22.75%

2. Competitor of Fan Plc

Beta = 1.54 Rf = 4 % Rm = 13 %

The cost of equity as per CAPM = Rf + Beta (Rm - Rf) = 4 % + 1.54 (13% - 4%) = 4 % + 1.54 * 9% = 17.86 %

The cost of debt = 8 % (1 - tax rate) = 8 % * (1 - 0.30) = 8 % * 0.70 = 5.6 %

Weight of debt = 0.40 and weight of equity = 0.60

WACC = Weight of equity * Cost of equity + Weight of debt * Cost of debt

Weighted average cost of capital of fan plc'c competitor = 17.86% * 0.60 + 5.6 % * 0.40 = 10.716 % + 2.24 % = 12.956 %