Southern Mining\'s outstanding debt has a before-tax cost of 6 percent and a cur

Question

Southern Mining's outstanding debt has a before-tax cost of 6 percent and a current market value  of $125 million.    The  market  value  of  the  firm's  outstanding  equity  is $75 million. Given  Southern's  current  financial/capital  structure,  the  firm's  cost  of  equity  capital  is 16 percent.  Southern is currently planning to issue an additional $25 million of equity in order to retire $25 million of outstanding debt.  Assuming that Southern's debt is currently risk free and that the corporate tax rate is zero (as are all personal income tax rates), determine

a.) the impact of recapitalization on Southern Mining's cost of equity capital.

b.)the impact of recapitalization on Southern Mining's WACC.

Explanation / Answer

Ro is THE REQUIRED RATE REQUIRED BY THE FIRM(THAT IS LONG TERM DEBT + EQUITY)

Ro = 6*(125/200) + 16*(75/200)

Ro = 9.75%

a.) the impact of recapitalization on Southern Mining's cost of equity capital.

9.75% = 6*(100/200) + Re(100/200)

0.5Re = 9.75- 3

Re = 13.5%

b.)the impact of recapitalization on Southern Mining's WACC.

WACC = 6*(100/200) + 13.5*(100/200)

=9.75% [SAME AS GIVEN IN THE QUESTION :-Assuming that Southern's debt is currently risk free and that the corporate tax rate is zero (as are all personal income tax rates)

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