Question

ABC company currently has an all equity capital structure. ABC has an expected operating income (EBIT) of $12,000. Assume that this EBIT figure is perpetual, that is to say, EBIT will continue at this same level forever. Its cost of equity (which is also its WACC since there is no debt financing currently) is 11.3 percent. ABC company has plans to issue $32,500 in debt at a cost of 5.4 percent in order to buy back a same amount of equity currently held by investors in financial markets.

Assume ABC company pays corporate taxes at a rate of 25 percent. Hence, we are in the “Modigliani Miller with taxes” world.

(a) Calculate the value of the all equity (i.e. unlevered) business.

(b) Calculate the value if the ABC company after it issues debt.

(c) Calculate the D/E ratio before and after the issuance of debt

(d) Calculate the cost of (levered) equity when the ABC company has $32,500 debt.

(e) Calculate the weighted average cost of capital with the new capital structure.

Answer 1

Ars » Cost of equity (K) = 11.3% EBIT = 12000 Value of Flrum = I (value of all the equity cash flow cost of Equity EBIT (1-1) 11.3% 12000(1-251.) 11.3% = $79646.02 value of all the equity b) value of equity after It Issue's debt & We have to buy back share amount - debt So we have to & Remove b. debt amount from value of all the equity = so Vale of ABC 79 646.02 - 32500 = $47 146.02 equity capital 6.02. Total capital of ABC - equity capital & debt capita > 47 146.02 + 32500 = $79646.02 so total capital Remain some by equity capital debt to Equity Ratio = 30 total clebt capital totul equity coppia = 32500 - 0.68935 471116.02 - 68.935 % c)

cort of Equity & levered So we have to figure out unlevere Beta than Relevered it all to DIE Rubio since it is equity finance of only dun levered Beta must be = 1 the Use hamuda equation Be a Bur (1 + (1-T) DIE) - 1 (1+ 41-25% ) ( 625796-02) ) fL = 1.517 from preurous We have to find Equity /market premium cost of equity CAPM = Rft & equity /market Premium) 11.3 = 5.4 + ß (equity Premium) 11.3-5.4 = 1 (equity Premium) equity premium = 5.9 %. New cost of equity. CAPM = REt Br (equity Premium) = 5.4 + 1.517 ( 5.9) New-cost of equity = 14.35 %

E) WACC = - cost of Equity & [ Debt & Ill-t) + Equity x total capital ( total capital 32500 x 5.4(1-25%) + 1 47146.02 x 7964602 79646.02 14.35 % ) WALL = 10.15 %