O’Connell & Co. expects its EBIT to be $95,000 every year forever. The firm can
ID: 2652052 • Letter: O
Question
O’Connell & Co. expects its EBIT to be $95,000 every year forever. The firm can borrow at 8 percent. O’Connell currently has no debt, and its cost of equity is 13 percent and the tax rate is 35 percent. The company borrows $133,000 and uses the proceeds to repurchase shares.
What is the cost of equity after recapitalization? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
What is the WACC? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
O’Connell & Co. expects its EBIT to be $95,000 every year forever. The firm can borrow at 8 percent. O’Connell currently has no debt, and its cost of equity is 13 percent and the tax rate is 35 percent. The company borrows $133,000 and uses the proceeds to repurchase shares.
Explanation / Answer
Answer
Answer No. 1
O’Connell & Co. expects its EBIT to be $95,000 every year forever. O’Connell currently has no debt, So there will not be interest and So EBT is $95,000 for perpetuity and So Earning after tax will be $ 61750 for perpetuity i.e. $ 95,000 * [1- 0.35 (tax rate) ].
Figures in $
Value of equity after repurchase
Particulars
Amount
Earning after tax for perpetuity
a
61750
Cost of equity
b
0.13
Value of the equity (a/b)
c
475000
Repurchase of share
d
133000
Value of equity after repurchase (c-d)
e
342000
Revised Earnings after borrowing
Figures in $
Particulars
Amount
EBIT for perpetuity
f
95000
Interest cost on borrowed amount
g
10640
( 133000 * 0.08)
EBT for perpetuity (f-g)
h
84360
Revised earning after tax for perpetuity (h*0.65)
i
54834
84360 * ( 1-0.35)
Cost of equity after recapitalization
Figures in $
Particulars
Amount
Revised earning after tax for perpetuity
i
54834
Value of equity after repurchase
e
342000
Cost of equity after recapitalization (i/e)
0.1603
Answer : Cost of equity after recapitalization is 16.03%
Answer No. 2
WACC = Cost of equity * ( Value of the equity/ total value of firm) + Cost of debt ( 1-tax rate) ( Value of the debt/ total value of firm)
=16.03% * (342000/475000) + 8% (1 – 0.35) ( 133000/475000)
= 16.03% * (0.72) + 5.20%*( 0.28)
=11.54% + 1.456%
=12.996%
Answer : The WACC is 12.996%
Figures in $
Value of equity after repurchase
Particulars
Amount
Earning after tax for perpetuity
a
61750
Cost of equity
b
0.13
Value of the equity (a/b)
c
475000
Repurchase of share
d
133000
Value of equity after repurchase (c-d)
e
342000
Revised Earnings after borrowing
Figures in $
Particulars
Amount
EBIT for perpetuity
f
95000
Interest cost on borrowed amount
g
10640
( 133000 * 0.08)
EBT for perpetuity (f-g)
h
84360
Revised earning after tax for perpetuity (h*0.65)
i
54834
84360 * ( 1-0.35)
Cost of equity after recapitalization
Figures in $
Particulars
Amount
Revised earning after tax for perpetuity
i
54834
Value of equity after repurchase
e
342000
Cost of equity after recapitalization (i/e)
0.1603
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