You have been asked to analyze the capital structure of CQ Inc, and make recomme

Question

You have been asked to analyze the capital structure of CQ Inc, and make recommendations on a future course of action. CQ Inc. has 40 million shares outstanding, selling at $20 per share and a debt-equity ratio (in market value terms) of 0.25. The beta of the stock is 1.15, and the firm currently has a AA rating, with a corresponding market interest rate of 10%. The current risk-free rate is 8% and the market risk premium is 5.5%.The firm's income statement is as follows:

$150 million

$20 million

$130 million

$52 million

$78 million

A) What is the firm's current weighted average cost of capital? Show calculations.

B) What will the new stock price be if they borrow $200 million and repurchase stock? Assume a beta of 1.40. Show calculations.

     EBIT

$150 million

     Interest Expense

$20 million

     Taxable Income

$130 million

     Taxes

$52 million

     Net Income

$78 million

Explanation / Answer

A) Calculation of WACC WACC = Cost of equity * weight of equity + Cost of debt* weight of debt Cost of equity = Risk free rate + Beta * Market risk premium = 8% + 1.15 *(5.5%) =14.325% Weight of equity = 1/(1+0.25) = 0.80 weight of debt = 0.25 / (1+0.25) = 0.20 Debt = 0.25 * Equity = 0.25 * (40 Million Shares *$20) =$ 200 Million interest in debt = $20 million Hence interest rate on debt = $20 Million / $200 million = 10% Taxable income = $130 million Tax   = $52 million hence tax rate = 52 / 130 = 0.40 = 40% Cost of debt = Interest rate * (1- tax) = 10% * (1-0.40) = 6% Hence WACC = = (14.325%*0.80) + (6% *0.20) = 12.66%

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