Question

4. River Cruises is all-equity-financed. Suppose it now issues $ 450,000 of debt at an interest rate of 10% and uses the proceeds to repurchase 45,000 shares. Assume that the firm pays no taxes and that debt finance has no impact on firm value. Rework showed below by selecting values per each scenario and account to show how earnings per share and share return vary with operating income after the financing.

 

5. Dunet is financed 40% by debt yielding 8%. Investors require a return of 18% on Donet's equity.

 a. What is the company's weighted average cost of capital if the corporate tax rate is 35%?

 b. What would be the company's cost of capital if it were exempted from corporate tax?

Answer 1

1-
state of economy	Slump	normal	boom
Profit before interest	100000	150000	200000
less Interest	45000	45000	45000
equity earning	55000	105000	155000
earning per share = equity earning/no. of shares   no. of shares = 100000-45000 =55000	1	1.91	2.82
return on shares = equity earnings/value of shares   value of shares = no of shares after repurchase* price per share	10.00%	19.09%	28.18%
2-
A-WACC = (weight of debt*after tax cost of debt)*(weight of equity*cost of equity)	(.4*5.2)+(.6*18)	12.88
after tax cost of debt	8*(1-.35)	5.2
B-WACC = (weight of debt*after tax cost of debt)*(weight of equity*cost of equity)	(.4*8)+(.6*18)	14