You are interested in the value of Gemini Corporation and its cost of capital. S

Question

You are interested in the value of Gemini Corporation and its cost of capital. Suppose you
believe that the assumptions of Miller-Modigliani's Proposition 1 (without taxes) are valid.
(a) Find the value of the company, the new cost of equity and WACC if the currently unlevered company, valued at $2,400,000 issues debt of $850,000 at 7% expected return. You can assume that the company uses this borrowing to repurchase stocks. Assume also that the initial cost of equity was 12%.
(b) Consider your answer this time with a corporate tax rate of 35%. You may assume that the value of the unlevered firm is still $2,400,000 even though taxes have gone from 0 to 35%.

Explanation / Answer

a.Value of company remains unchanged= $2400000

New cost of equity = 12% + 850000/(2400000-850000)*(12%-7%)= 14.74%

WACC = 850000/(2400000)*7% + (2400000-850000)/ (2400000)*14.74%= 12%

b. Value of firm = 2400000+ 850000*35%=2697500

Equity = 2697500-850000=1847500

New cost of equity = 12% + 850000/1847500*(12%-7%)*(1-35%)= 13.50%

WACC = 850000/(2697500)*7%*(1-35%) +1847500/ (2697500)*13.50%=10.68%

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