O?Connell & Co. expects its EBIT to be $91,000 every year forever. The firm can
ID: 2639368 • Letter: O
Question
O?Connell & Co. expects its EBIT to be $91,000 every year forever. The firm can borrow at 4 percent. O?Connell currently has no debt, and its cost of equity is 9 percent and the tax rate is 35 percent. The company borrows $136,000 and uses the proceeds to repurchase shares.
What is the cost of equity after recapitalization?
O?Connell & Co. expects its EBIT to be $91,000 every year forever. The firm can borrow at 4 percent. O?Connell currently has no debt, and its cost of equity is 9 percent and the tax rate is 35 percent. The company borrows $136,000 and uses the proceeds to repurchase shares.
Explanation / Answer
Answer:
Assuming the dividend payout of the company is 100%, the cost of equity could be calculated by the price earnings ratio. The Cost of equity of the company = inverse of the P/E ratio = earnings / price.
The cost of equity of the company is 9%.
When the company was financed by equity,
EBIT $91,000
Less: Tax @35% $31850
PAT $59150
Therefore,
Total earnings / total market price of share = cost of equity = 0.09
=> Market Value of shares = PAT / cost of equity = 59150/0.09 = $657222
The company borrowed $136000 @ 4%,and used the proceeds to repurchase the shares. The total market value of shares after repurchase = 657222
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