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’s current stock price). Rockwood has the ability to borrow at a rate of 5% or to issue new equity at $25 per share. (a) If Rockwood finances their expansion by issuing new stock, what will Rockwood’s cost of equity capital be? (1) 12% (2) 15% (3) 8% (4) 10%

Explanation / Answer

Current Equity value = 16,000,000 * 25 = 400,000,000

After issuing new equity of $100 million, total equity would be $500 million

Since EBIT is given as $50 million, and since i=firm is debt free its interest is 0

Since tax rate is not given, it is assumed as 0%

So Cost of equity = return on equity = 50 / 500 = 10%

option(4)

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