If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Bernie’s is in the 25 percent state-plus-federal corporate tax bracket, its unlevered beta is .98, the risk-free rate is 2.5 percent, and the market risk premium is 8.5 percent.
The company’s EBIT was $300 million last year and is expected to grow at a rate of 3% per year forever. The firm is currently financed with all equity and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firm’s owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm’s investment banker the following estimated costs of debt for the firm at different capital structures:
|
% Debt |
rd |
|
0% |
|
|
10% |
7.00% |
|
20% |
7.50% |
|
30% |
9.00% |
|
40% |
11.75% |
| Debt % | rd | Beta | re | WACC |
| 0% | 0% | 0.98 | 10.83% | 10.83% |
| 10% | 7% | 1.06 | 11.52% | 10.90% |
| 20% | 7.50% | 1.16 | 12.39% | 11.04% |
| 30% | 9% | 1.30 | 13.51% | 11.48% |
| 40% | 11.75% | 1.47 | 15.00% | 12.52% |
Levered beta = Unlevered beta x (1 + (1 - tax) x Debt / Equity)
Cost of equity, re = Rf + beta x MRP
WACC = we x re + wd x rd x (1 - tax)
As the WACC is lowest at 0% debt, it is the optimal capital structure.
If the company were to recapitalize, debt would be issued, and the funds received would be...
If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Bernie’s is in the 25 percent state-plus-federal corporate tax bracket, its unlevered beta is .98, the risk-free rate is 2.5 percent, and the market risk premium is 8.5 percent. The company’s EBIT was $300 million last year and is expected to grow at a rate of 3% per year forever. The firm is currently financed with all equity and it...
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