A consultant has collected the following information regarding Young Publishing:
ID: 2723679 • Letter: A
Question
A consultant has collected the following information regarding Young Publishing:
Total assets $3,000 million Tax rate 40%
Operating income (EBIT) $800 million Debt ratio 0%
Interest expense $0 million WACC 10%
Net income $480 million M/B ratio 1.0×
Share price $32.00 EPS = DPS $3.20
The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). The consultant believes that if the company moves to a capital structure financed with 20 percent debt and 80 percent equity (based on market values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt will be 10 percent. If the company makes this change, what would be the total market value of the firm? (The answers are in millions.)
Explanation / Answer
Value of debt = $3,000 million * 20% = $600 million
Interest cost = $600 million * 10% = $60 million
EBIT = $800 million
EBT = EBIT - Interest cost = $800 million - $60 million = $740 million
Tax rate = 40%
Net income = EBT * (1 - tax rate) = $740 million * (1 - 0.40) = $444 million
WACC = 11%
Value of equity = Net income/WACC = $444 million / 0.11 = $4,036.36 million
Market value of firm = Value of equity + value of debt = $4,036.36 million + $800 million = $4,836.36 million
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