Question

Meyer & Co. expects its EBIT to be $115,000 every year forever. The firm can borrow at 9 percent. The company currently has no debt, and its cost of equity is 13 percent and the tax rate is 23 percent. The company borrows $168,000 and uses the proceeds to repurchase shares.

  

a.	What is the cost of equity after recapitalization? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	What is the WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Solution:
a.	Cost of Equity	13.94	%
Working Notes:
	Cost of Equity after recapitalization means debt is introduced and the firm become Levered firm and the cost of equity (levered) is asked.
	Unlevered value of the firm Vu
	Vu = EBIT x (1- tax rate )/ Cost of Equity unlevered
	Vu = EBIT x (1- tax rate )/R0
	Vu = 115000 x (1- 0.23 )/13%
	Vu = 681153.846154
	Levered value of the firm VL
	VL = Vu + Borrowing x tax rate
	VL = 681153.846154 + 168000 x 23%
	VL =719793.846154
	Now using M&M Proposition II with taxes
	value of the levered firm VL = Borrowing + Value of Equity
	VL = B + S
	719793.846154 = 168000 + S
	Market value of Equity S = 719793.846154 - 168000
	Market value of Equity S =551793.846154
	Using M&M Proposition II with taxes
	RS = R0+ (R0-RB)(B/S)(1- Tc)
	Where
	B/s = debt equity ratio =168000/551793.846154
	RS is cost of equity capital levered = ??
	R0 is cost of equity capital of unlevered firm = 13%
	RB is Cost of Borrowing = 9%
	Tc = tax rate = 23%
	RS= R0+ (R0-RB)(B/S)(1-Tc)
	Rs =13% + (13% - 9%) x (168000/551793.846154) x ( 1- 0.23)
	Rs =13% + 0.93774152%
	Rs =13.93774152%
	Rs =13.94%
b.	WACC	12.30	%
Working Notes:
	After tax cost of debt (Kd) = Cost of debt = 9% x (1-tax rate)
	Kd= =9% x (1-0.23) = 6.93%
	Cost of common equity (Ke)=13.93774152%
	VL = B + S
	Market value of Equity S =551793.846154
	VL =719793.846154
	B = 168,000
WACC= Ke x S/V + Kd   x B/V
WACC = 13.93774152% x (551793.846154/719793.846154) + 6.93% x (168000/719793.846154)
WACC = 0.123021335
WACC = 12.30%
Please feel free to ask if anything about above solution in comment section of the question.