Question

Assume the following data for TONINO Corp:

• Expected EBIT = $160 million (in perpetuity)
• Cost of unlevered equity = 8%
• Market risk premium = 5%
• Risk free rate = 4%
• The corporate tax rate =25%
• Currently TONINO is unlevered with twenty-million shares outstanding. Before the market opens TONINO will announce the change of capital structure from all equity finance to a debt-equity ratio of 0.5. Consol bonds (perpetuities) will be issued to repurchase shares of common stock 8 days after the announcement. The investment grade of Bonds is AAA and are considered riskfree. Assume markets are efficient in the semi-strong form.

Based on above information calculate:

1. The value of the firm unlevered
2. The share price of the firm unlevered
3. The cost of equity of the levered firm.
4. The weighted average cost of capital
5. The value of the firm levered using r_wacc
6. The share price of the firm immediately after announcing the change of capital structure from unlevered to levered.
7. Value of debt to be issued (8 days after the announcement)
8. #shares to be repurchased with debt (8 days after the announcement)
1. # shares outstanding after the repurchase
10. Value of equity (S^L)
11. Price of stock after the share repurchase with bonds (6 days after the announcement)
12. EPS^L
13. ROE^L
14. The value of the firm based on MM proposition I with corporate tax
15. Which capital structure should the firm select when corporate taxes are included (unlevered or levered)? Explain.

Answer 1

(a)

EBIT = 16000000

less: tax @ 25% -4000000

Net income = 12000000

Cost of unlevered equity= 8%

Value of unlevered firm in perpetuity =Expected Net income/cost of unlevered equity

12000000/8%

150000000

So, value of unlevered firm is $150,000,000

(b)

Share price of unlevered firm = Value of firm/no. of shares

No of shares= 20000000

Share price =150,000,000/20,000,000

7.5

So, share price of unlevered firm is $7.5

(c) As per CAPM model,

cost of Equity = Risk free rate + (Beta*market risk premium)

put values in equation to find out beta

8% = 4% + (Beta*5%)

4% = Beta * 5%

Beta = 4%/5%= 0.80

So, unlevered beta is 0.80

now, debt to Equity ratio is 0.5

so debt = 0.5

Equity = 1

Levered beta or Equity beta formula = Unlevered or Asset beta * (1 +( (1-tax rate)*Debt/Equity))

levered beta = 0.80 *(1+((1-25%)*0.5/1)

1.1

So, new cost of levered equity as per CAPM = 4% + (1.1*5%)

9.50%

so, cost of levered equity is 9.5%

(d)

debt to Equity ratio is 0.5

so weight of debt = 0.5

weight of Equity = 1

New Bonds are riskfree, so pre-cost of debt will be equal to Risk free rate=4%

After-tax cost of debt = pre-tax cost*(1-tax rate)

4%*(1-25%)

3.00%

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

(0.5*3%)+(1*9.50%)

11.00%

So, WACC is 11%