Rockwood Enterprises is currently an all equity firm and has just announced plan
ID: 2669322 • Letter: R
Question
Rockwood Enterprises is currently an all equity firm and has just announced plans to expand its current business. In order to fund this expansion, Rockwood will need to raise $100 million in new capital. After the expansion, Rockwood is expected to produce earnings before interest and taxes of $50 million per year in perpetuity. Rockwood has already announced the planned expansion, but has not yet determined how best to fund the expansion. Rockwood currently has 16 million shares outstanding and following the expansion announcement these shares are trading at $25 per share (hence, any positive NPV is already reflected into Rockwood’s current stock price). Rockwood has the ability to borrow at a rate of 5% or to issue new equity at $25 per share.If Rockwood finances their expansion by issuing $100 million in debt at 5%, what will Rockwood’s cost of equity capital be?
(1) 11.25%
(2) 10.70%
(3) 12.50%
(4) 12.00%
Explanation / Answer
Rockwood Enterprises is currently an all equity firm and has just announced plans to expand its current business. In order to fund this expansion, Rockwood will need to raise $100 million in new capital. After the expansion, Rockwood is expected to produce earnings before interest and taxes of $50 million per year in perpetuity. Rockwood has already announced the planned expansion, but has not yet determined how best to fund the expansion. Rockwood currently has 16 million shares outstanding and following the expansion announcement these shares are trading at $25 per share (hence, any positive NPV is already reflected into Rockwood’s current stock price). Rockwood has the ability to borrow at a rate of 5% or to issue new equity at $25 per share.
If Rockwood finances their expansion by issuing $100 million in debt at 5%, what will Rockwood’s cost of equity capital be?
(1) 11.25%
(2) 10.70%
(3) 12.50%
(4) 12.00%
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