Rockwood Enterprises is currently an all equity firm and has just announced plan

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

Explanation / Answer

1. Equity post expansion = $100M/$25+16M =20M shares

EBIT = $50M

So EPS = EBIT/No of shares = $50M/20M = $2.50 per share.

SO Cost of equity = EPS/Mkt Price = $2.50/$25 = 10%

2.Total capital = Debt+Equity = $100M+16M*$25 = $500M

So Debt weight Kd = 100/500 = 20%

& Equity weiight We = 400/500 = 80%

EBIT = $50M

Less Int5%*$100M = $5M

----------------------

EBT = 45M

So EPS = EBIT/No of shares = $45M/16M = $2.81 per share.

SO Cost of equity = EPS/Mkt Price = 2.81/25 = 11.24%

3. In above, we see that current stock price is not affected by issuing fresh stock or issue of debt. It is entirely Mkt driven

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