Question

NEED ALL OF THE SUBJECTS SOLVED

Q Inc. is an all equity financed company in the country which does not have any corporate taxes. The company has an EBIT of $2 million and EBIT is expected to grow at 6% per year forever. The cost of equity for OQ Inc. is 18%. Currently, the company has 625,000 shares of common stock outstanding.

a. Determine the EBIT that would make the company indifferent between 35% debt and 65% equity financing, and 100% equity financing.Given the break-even EBIT and the EBIT the company has, indicate and briefly justify the capital structure that should be preferred by the firm. Briefly discuss if the value of the firm with the capital structure would be higher, lower or the same as the value of the firm with its all equity financed capital structure. of this question.

b. Calculate the cost of equity and the weighted average cost of capital for the firm with the capital structure you indicated in part (a) of this question.

c. Suppose today is two years later and the country decides to have a corporate tax rate of 40%. Suppose OQ Inc. stayed as an all equity financed firm for the past two years. Calculate the value of OQ Inc. when there is a 40% corporate tax.

d. Suppose OQ Inc. decides to issue $3 million worth of bonds and use this money to buy back some of its shares. The interest rate on these bonds will be 10% per year. Calculate the value of the OQ Inc. and value of its equity with this new capital structure when there are corporate taxes.

e.Briefly explain the reason for the difference in value of the firm you calculated in parts (d) and (c) of this question.

f. Calculate the cost of equity and the weighted average cost of capital the company will have with its new capital structure when there is 40% corporate tax rate.

Answer 1

Ans (a). Current EBIT = $2,000,000 Current Market Value of Firm = $2millions / 18% = $11,111,110 Current EPS = $2million / 625,000 = $3.2/share Break-even EBIT is an EBIT where the earnings of the equity shareholders remains unaffected after deduction of interest expenses. Interest Expenses = ($11,111,110 x 0.35 x 10%) [Supposing that debt is borrowed at 10% pa interest]    = $ 388,890

Therefore, Break even EBIT = $2,388,890

Ans (b). Cost of Equity = 18%     Weighted Average Cost of Capital = [(18% x 0.65) + (10% x 0.35)] = 15.20%

Ans (c). Value of the firm = $11,111,110 x 1.06 x 1.06 = $12,484,443

Ans (d). Value of the firm = ($11,111,110 x 1.06 x 1.06) - $3,000,000 = $9,484,443

Ans (e). When shares are bought back and bonds are issued, it gives rise to an increase in interest expenses.

Ans (f). Cost of Equity = 18% Weighted Average Cost of Capital = [(18% x 0.65) + (10% x 0.6 x 0.35)] = 13.80%