Question

please slove and explain how answer was obtained

CAPITAL STRUCTURE PROBLEM The following data condition firm's current financial reflect a Value of debt (book value=narket value) $5,000 , 000 $ 25,000,000 $ 30,000,000 $ 5,500,000 40% Market value of equity (Po x shares) Total Value of firm ЕBIT Tax Rate (T) At the current level off debt, the cost of debt (k,) is 10% and the firm's beta 1.5. The firm is questioning the possibility of issuing $1,500,000 of additional debt proceeds to repurchase stock. If it does, the interest on new debt would rise to 12% and beta would rise to 2.0 10% debt would remain outstanding.) E[R]108 and R, 68. and using the (The old (1) Calculate the value of the firm at the higher level of debt and decide if the firm should increase its debt to $6,500,000. (2) The market price of the firm's stock was originally $25.00. Calculate the new stock price (P') at a debt level of $6,500 , 000 . (3) Calculate the value of EPS under the original debt level of $5,000,000 and its value under the higher debt level of $6,500,000. (4) How does your answer to (3) influence the decision you made in answering (1)? EXPLAIN! (5) calculate the WACC, k, at the original debt level of $5,000,000. (6) Calculate the WACC, k, at the new debt level of $6,500,000. Do the results of (5) and (6) above contradict or support the decision you made in answering (1)? EXPLAIN! (7)

Answer 1

1) The value of the firm remains the same under both the circumstances Old and New as market value of debt will be added to the debt value and the same will decrease the equity value by market price as the firm will repurchase the stock based on the market price of the stock which is $25.

Particulars	Old Value	New Value
Market Value = Book Value of Debt	5000000	6500000
Market Value of Equity	25000000	23500000
Total	30000000	30000000

Market Value remains the same. The firm should take additional debt will be based on cost of capital and earnings per share that we will calculate further.

2) The firm is engaging in the stock repurchase of $1,500,000 of additional debt through which it will be able to buy 60,000 shares 1,500,000/25. The stock price of the company will remain the same.

Please find the calculation for it. 25 * 1,000,000 = 25,000,000

25,000,000 - 1,500,000/ (1,000,000 - 60,000)

= 25.

3) Now we will calculate the EPS  

Particulars	Old Debt Level	New Debt level
EBIT	5500000	5500000
(Interest @ 10% for old debt level and @12% for new debt level	550000	660000
EBT (earnings before tax)	4950000	4840000
TAX @ 40%	1980000	1936000
PAT (profit after tax)	2970000	2904000
No of Shares	1000000	940000
EPS	2.97	3.09

4) Based on EPS it would be suggested that the new debt should be taken, as the interest on debt is tax-free it adds earnings to the shareholders. So based on EPS I would recommend to take additional debt. The important factor is debt's interest is tax deductible.

5 & 6) First we will calculate the cost of Equity using the CAPM formula

Cost of Equity = RF + Beta*(RM - RF)

For old debt levels: 6 + 1.5*(10-6) = 12

For new debt levels: 6 + 2*(10-6) = 14

Now we will calculate the WACC: (Weight of debt * After TAX cost of Debt) + (Weight of Equity * Cost of Equity)

Particulars Old Debt levels	Amount	Weights	Tax	Cost	After Tax Cost	WACC
Equity	5000000	16.67%	40.00%	10.00%	6.00%	1.00%
Debt	25000000	83.33%		12.00%	12.00%	10.00%
Total Capital	30000000					11.00%
Particulars New Debt Levels	Amount	Weights	Tax	Cost	After Tax Cost	WACC
Equity	6500000	21.67%	40.00%	12.00%	7.20%	1.56%
Debt	23500000	78.33%		14.00%	14.00%	10.97%
Total Capital	30000000					12.53%

Based on Cost of capital I would not recommend to add new debt as it adds risk to the equity that's why its beta is increasing from 1.5 to 2 and the cost of debt increasing to 12% from 10%