Question

Capital Structure Analysis

Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company's EBIT is $13.66 million, and its tax rate is 25%. Pettit can change its capital structure either by increasing its debt to 60% (based on market values) or decreasing it to 40%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 14% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 9% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change.

The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of equity, r_s, is 14%. If it increases leverage, r_s will be 16%. If it decreases leverage, r_s will be 13%.

Present situation (50% debt):
What is the firm's WACC? Round your answer to three decimal places.
     %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$    million

60% debt:
What is the firm's WACC? Round your answer to two decimal places.
       %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$    million

40% debt:
What is the firm's WACC? Round your answer to two decimal places.
       %
What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places.
$   million

Answer 1

50% Debt:

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [0.50 x 10% x (1 - 0.25)] + [0.5 x 14%] = 3.75% + 7% = 10.75%

Total Corporate Value = $100 million

60% Debt:

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [0.60 x 14% x (1 - 0.25)] + [0.4 x 16%] = 6.3% + 6.4% = 12.70%

Value of levered firm = value of unlevered firm + [(1 - tax rate)* value of debt]

Value of unlevered firm = Current Value - [Debt x (1 - t)]

= 100 - [50 x (1 - 0.25)] = 100 - 37.5 = $62.50 million

Value of levered firm = 62.50 + [(1 - 0.25) * (60% x Value of levered firm)]

Value of levered firm = 60.5 + 0.45(Value of levered firm)

0.55(Value of levered firm) = 60.5

Value of levered firm = 60.5/0.55 = $110 million

40% Debt:

WACC = [wD x kD x (1 - t)] + [wE x kE]

= [0.40 x 9% x (1 - 0.25)] + [0.6 x 13%] = 2.7% + 7.8% = 10.50%

Value of levered firm = value of unlevered firm + [(1 - tax rate)* value of debt]

Value of levered firm = 60.5 + [(1 - 0.25) * (40% x Value of levered firm)]

Value of levered firm = 60.5 + 0.30(Value of levered firm)

0.70(Value of levered firm) = 60.5

Value of levered firm = 60.5/0.70 = $86.429 million