Question

1. Firm X is solely financed by $1 million equity at cost of 10%. X wants to raise $0.6 million debt at cost of 4% and use all of it to buy back outstanding equity. a) In a perfect capital market, what will be its new firm value V. WACC and cost of levered equity ry after the buyback? b) In a capital market with corporate taxes, what will be its new firm value VL. WACC and cost of levered equity Tg after the buyback?

Answer 1

${\displaystyle r_{E}({\text{Levered}})=r_{E}({\text{Unlevered}})+{\frac {D}{E}}(r_{E}({\text{Unlevered}})-r_{D})}$

=10%+0.60/0.40(10%-4%)

=10%+9%

=19%

Cost of levered equity=19%

WACC=6.4%

Amount	Cost	Weights	Weighted Cost
400000	10%	0.4	4%
600000	4%	0.6	2.4%
1000000
			6.4%

$r_{E}=r_{0}+{\frac {D}{E}}(r_{0}-r_{D})(1-T_{C})$