A firm has an expected perpetual EBIT = $6,000. The unlevered cost of capital =
ID: 2722799 • Letter: A
Question
A firm has an expected perpetual EBIT = $6,000. The unlevered cost of capital = 8% and there are 20,000 shares of stock outstanding. The firm is considering issuing $10,000 in new par bonds to add financial leverage to the firm. The proceeds of the debt issue will be used to repurchase equity. The cost of debt = 5% and the tax rate is 34%. There are no flotation costs.
What is the value of the firm before restructuring?
What is the value of the firm after restructuring?
What is the value of the equity after the restructuring?
What is the cost of equity after restructuring?
Explanation / Answer
Current Details Amt $ Perpetual EBIT = 6,000 Tax Rate =34% Tax = 2,040 Perpetual Post Tax Income = 3,960 Unlevered cost of Equity =kUG= 8% Unlevered Firm Value =3960/8%= 49,500 No of outstanding common stock 20,000 Stock value per share = $ 2.48 a So value of firm before restructuring= 49,500 b After Restructuring ; Value of debt = 10,000 Interest cost @5% 500 Perpetual value of interest =500/5%= 10,000 Tax shield on interest =34%*10000 3,400 So Value after resturcturing =Unlevered value+PV of Tax benefits of interest= $ 52,900.00 c Value of Firm after restructuring 52,900 Value of Debt 10,000 So Value of Equity afetr restructurinh 42,900 d Cost of Equity ungeared =kUG=8% Cost of Debt =kD=5% t=Tax Rate =34% Assume cost of Geared Equity =kG kG=kUG+[(1-t)*D/E*(kUG-kD) kG=0.08+0.66*(10000/42900)*(0.03) 8.46% So cost of Equity after restructuring =8.46%
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