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 $11.60 million, and its tax rate is 20%. Pettit can change its capital structure by either 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 11% coupon. If it decides to decrease its leverage, it will call 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 - 0.20)] + [0.5 x 14%] = 4% + 7% = 11%

Total Corporate Value = $100 million

60% Debt:

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

= [0.60 x 11% x (1 - 0.20)] + [0.4 x 16%] = 5.28% + 6.4% = 11.68%

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 - 0.20)] = 100 - 40 = $60 million

Value of levered firm = 60 + [(1 - 0.20) * (60% x Value of levered firm)]

Value of levered firm = 60 + 0.48(Value of levered firm)

0.52(Value of levered firm) = 60

Value of levered firm = 60/0.52 = $115.385 million

40% Debt:

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

= [0.40 x 9% x (1 - 0.20)] + [0.6 x 13%] = 2.88% + 7.8% = 10.68%

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

Value of levered firm = 60 + [(1 - 0.20) * (40% x Value of levered firm)]

Value of levered firm = 60 + 0.32(Value of levered firm)

0.68(Value of levered firm) = 60

Value of levered firm = 60/0.68 = $88.235 million