Question

Remax(RMX) currently has no debt in its capital structure. The beta of its equity us 1.52. For each year into the indefinite future. Remex's free cash flow is expected to equal 30 million. Remex is considering changing its capital structure by issuing debt and using the proceeds to buy back stock. It will do so in such a way that it will have a 35% debt-equity ratio after the change and will maintain this debt-equity ratio forever. Assume that Remex's debt cost of capital will be 5.98%. Remex faces a corporate tax rate of 30%. Except for the corporate tax rate of 30%, there are no market imperfections. Assume that the Capm holds, risk-free rate of interest is 4.6% and the expected return on the market is 10.12%.

Debt cost of capital is 5.98%

a). using the information provided fill in the table below

b) using the value of the information provided and your calculations in part a determine the value of the tax shield acquired by Remex if it is changing its capital structure in the way it is considering

Before change in Capital Structure:   Debt Ratio Debt Debt Cost of Capital Equity cost of Cap. Weighted Average

0 N/A ? ?

After change in Capital Structure 0.35% 5.98% ? ?

The value of the tax shield is ?

Answer 1

a	Cost of equity
	Cost of equity = Risk free rate of return+beta x (market rate of return-risk free rate of return)
	Beta	1.52
	Market rate of return	10.12%
	Risk free rate of return	4.60%
	Cost of equity = 4.6%+1.52(10.12-4.6)
	= 4.6%+8.39%
	=12.99% or 13%
	If there is no debt, WACC is equal to cost of equity
	After the change, cost of equity is:
	12.99% + 0.35 (12.99%-5.98%)= 15.44%
	After the issue of debt, the WACC is:
	WACC = Cost of equity x equity ratio + debt ratio x Cost of debt (1-tax rate)
	Equity ratio	0.74	(1/1.35)
	Cost of equity	12.99%
	Debt ratio	0.26	(0.35/1.35)
	Cost of debt	5.98%
	Tax rate	30%
	WACC = 0.74 x 15.44%+ 0.26 x 5.98% x (1-0.30)
	= 11.43% + 1.088%
	= 12.518% or 12.52%
b	Now, we will compare the value with and without leverage
	Without leverage
	Free Cash Flow	$30,000,000
	Return on equity	12.99%
	Value (30 million/12.99%)	$230,946,882
	With leverage
	Free Cash Flow	$30,000,000
	Weighted average cost of capital	12.52%
	Value (30 million/12.99%)	$239,616,613
	Tax shield ($239,616,613-230,946,882)	$8,669,731
	Table
		Debt Equity Ratio	Debt Cost of Capital	Equity Cost of Capital	Weighted Average cost of Capital
	Before changes in Capital Structure	0	N/A	12.99%	12.99%
	After changes in Capital Structure	0.35	5.98%	15.44%	12.52%