O Grady Ltd is a company that makes cardboard shipping boxes. Currently, the company is financed entirely by equity. The board is analyzing whether the firm should recapitalize itself to include leverage in its capital structure. The firm’s equity beta is 1.2, and the expected return on the market is 13%. Based on an examination of bonds, you believe the risk-free rate of return is 8%. Several of your competitors are public companies. After reviewing financial statements for these competitors, managers learn that the average firm in this group maintains a debt-to-total-value level of about 40%. Firms in this industry have a cost of debt around 10%, and you believe that if O Grady Ltd issues debt, it will also cost about 10%. Corporate taxes are currently 28%. O Grady Ltd is currently composed of a single project that generates $150 000 per year. This project is anticipated to continue forever (in other words, it is a perpetuity). You have been hired to analyze whether O Grady Ltd should recapitalize. You are preparing a report. For your report to the board, you need to: Determine the current cost of capital for O Grady Ltd as an all-equity financed firm Determine the value of O Grady Ltd if it remains all-equity financed Find the new cost of capital if O Grad Ltd leverages itself to the industry norm (40% debt) Calculate what the firm’s new value would be based on this new cost of capital Based on your analysis, make a recommendation to the board about whether or not to recapitalize with debt. In your recommendation, cite the specific information you learned in calculating the cost of capital. Explain the rationale for your decision.
| cost of capital for all equity firm | Risk free rate+(market rate of return-risk free rate)*beta | 8+(13-8)*1.2 | 14 |
| value of firm-all equity firm | annual income for perpetuity/cost of capital | 150000/14% | 1071428.57 |
| weighted average cost of capital for levered firm | (weight of debt*after tax cost of debt)*(weight of equity*cost of equity) | (.4*7.2%)+(.6*14%) | 11.28% |
| after tax cost of debt = before tax cost of debt*(1-tax rate) | 10%*(1-.28) | 7.2% | |
| value of firm-levered firm | annual income for perpetuity/weighted average cost of capital | 150000/11.28% | 1329787.23 |
| company should capitalize with the debt in its capital structure as it will increase the value of firm due to tax benefit of interest expense as it is tax deductible expense |
O Grady Ltd is a company that makes cardboard shipping boxes. Currently, the company is financed entirely by equity. The...
Your firm is financed 100% with equity and has a cost of equity capital of 13%. You are considering your first debt issue, which would change your capital structure to 34% debt and 66% equity. If your cost of debt is 6%, what will be your new cost of equity? Assume no change in your firm's WACC due to the change in capital structures.
Your firm is financed 100% with equity and has a cost of equity capital of 15%. You are considering your first debt issue, which would change your capital structure to 34% debt and 66% equity. If your cost of debt is 7%, what will be your new cost of equity? Assume no change in your firm's WACC due to the change in capital structures.
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