A levered company currently expects zero growth. It has an expected EBIT of $65,

Question

A levered company currently expects zero growth. It has an expected EBIT of $65,000 and 13,000 shares outstanding. The corporate tax rate is 40%. It has a beta of 1.4, risk-free rate of 5%, and market risk premium of 7%. The weight and cost of debt are 30% and 14.5% respectively. What is current price per share? If the company recapitalizes to 40% debt at a cost of 15%, what would the new price per share be?

Current: $23.13; New $13.67

Current: $16.19; New $13.67

Current: $23.13; New $25.00

Current: $16.19; New $15.88

THE ANSWER IS D $16.19; New $15.88. HOW DO I GET THAT?

Explanation / Answer

The value of debt in the capital structure has not been provided in the question. Therefore, the interest part has not been taken into consideration in solving the question. Here, the value of the levered firm is same as value of unlevered firm.

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Part A)

To calculate the stock price, we need to determine the weighted average cost of capital and value of the firm. Since, the firm has taxes, the value of the firm will be calculated with the use of following formula:

Value of the Firm = EBIT*(1-Tax Rate)/WACC

WACC = Weight of Debt*Cost of Debt*(1-Tax Rate) + Weight of Equity*Cost of Equity

Price Per Share = Value of the Firm/Number of Outstanding Shares

Cost of Equity = Risk Free Rate + Beta*Market Risk Premium

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Here, Weight of Debt = 30%, After-Tax Cost of Debt = 14.5%*(1-40%), Weight of Equity = 70% and Cost of Equity = 5 + 1.4*7 = 14.8%

WACC = 40%*14.5%*(1-40%) + 60%*14.8% = 12.97%

Value of the firm = 65,000*(1-40%)/12.97% = $300,693.91

Current Price Per Share = $300,693.91/13,000 = $23.13

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Part B:

Here, we will have to calculate the revised value of EBIT which will include a benefit of tax deduction resulting from an increase in the proportion of debt.

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Here, Weight of Debt = 40%, After-Tax Cost of Debt = 15%*(1-40%), Weight of Equity = 60% and Cost of Equity = 5 + 1.4*7 = 14.8%

WACC = 40%*15%*(1-40%) + 60%*14.8% = 12.48%

Value of the firm = (65,000*(1-40%) + 65,000*40%*15%*40%)/12.48% = $325,000

Price Per Share = 325,000/13,000 = $25

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Answer is: Current: $23.13; New $25.00 (which is Option C)

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