Martha Grapvines INC. is 100% equity financing and has an expected perpetual EBI

Question

Martha Grapvines INC. is 100% equity financing and has an expected perpetual EBIT = $4,000. The firms cost of equity is 15%. The firm is considering issuing $8,800 in new par bonds to add financial leverage to the firm. The proceeds of the debt will be used to repurchase equity. The cost of debt is 10% and the tax rate is 30%.

a) What is the value od the firm under current capital structure of 100% equity financing?

b) What will the value be if Marthas Grapvine Inc. Borrows $8,800 and uses the proceeds to repurchase shares?

c) What is the cost of equity after recapitalization?

d) What is the weighted average cost of capital (WACC) after recapitalization?

Explanation / Answer

a) Value of the firm = PV of EBIT in perpetuity=A/I , where A=Annual stream of cash , i=Cost of equity Income after tax=4000*(1-Tax Rate)=4000*(1-0.30) 2800 Value of the firm=PV of Income in Perpetuity=A/i=2800/0.15 18666.67 b) Cost of debt=Interest*(1-Tax rate)=10*(1-0.30) 7 Here , debt=8800 and equity=18666.67-8800= 9866.67 Weight of debt=8800/18666.67 0.47 Weight of equity=1-0.47 0.53 WACC=Weight of debt*cost of debt+Weight of equity*cost of equity=0.47*7+0.53*15 11.24 Income after interest and tax =(4000-0.10*4000)*(1-0.30) 2520 Value of the firm=2520/WACC=2520/0.1124 22419.93 c) Cost of equity will remain same at 15% d)WACC=11.24%

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