Brown Fabricators, Inc. (BF) currently has zero debt. It is a zero growth compan
ID: 2670829 • Letter: B
Question
Brown Fabricators, Inc. (BF) currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. (Hint1: assume a zero-growth firm will not make any new investments in operating capital when calculating FCF.) (Hint2: remember how we calculated firm value for a zero-growth firm in class, given FCF and WACC.)EBIT = $100,000 New Debt/Value = 30%
Growth = 0% New Equity/Value = 70%
Orig cost of equity, rs = 10.0% No. of shares = 20,000
New cost of equity = rs = 11.0% Price per share = $24.00
Tax rate = 40% Interest rate = rd = 7.0%
1. If this plan were carried out, what would be VF's new WACC and its new value of operations?
WACC Value
a. 8.96% $669,643
b. 9.83% $610,376
c. 10.03% $598,205
d. 10.23% $528,402
e. 10.74% $538,970
Explanation / Answer
According to the given information,
EBIT = $100,000
Weight of debt (Wd) = 30%
Weight of equity (We) = 70%
New cost of equity (Re) = 11%
Cost of debt (Rd) = 7%
Growth rate (g) = 0%
Tax rate (Tc) = 40%
Calculating the WACC using the below formula:
WACC = [Wd * Rd * (1-Tc)] + (We * Re)
= [0.30 * 0.07 * (1-0.40)] + (0.7 * 0.11)
= 0.0126 + 0.077
= 0.0896 or 8.96%
Therefore, the Weighted average cost of capital is 8.96%
The value of operations is calculated as
Value of operations = [Free cash flows (1 + g)] / (WACC - g)
Taxes on EBIT = 40% ($100,000)
= $40,000
Free cash flows = Operating cash flows - Capital expenditures
= (EBIT + Depreciation - Taxes) - Capital expenditures
= ($100,000 + $0 - $40,000) - $0
= $100,000 - $40,000
= $60,000
Value of operations = [Free cash flows (1 + g)] / (WACC - g)
= [$60,000 (1+0)] / (0.0896 - 0)
= $60,000 / 0.0896
= $669,643
Therefore, the value of operations is $669,643
Hence, the correct option is a) 8.96%, $669,643
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