ABC, a consumer goods manufacturer, is evaluating its capital structure. The bal

Question

ABC, a consumer goods manufacturer, is evaluating its capital structure. The balance sheet of the company is as follows (in millions) The debt is in the form of long-term bonds, with a coupon rate of 10%. The bonds are currently rated AA and are selling at a yield of 12% (the market value of the bonds is 80% of the face value). The firm currently has 50 million shares outstanding, and the current market price is $80 per share. The firm pays a dividend of $4 per share and has a price learnings ratio of 10. The stock currently has a beta of 1.2. The risk free rate is 8%. The tax rate for this firm is 30%. ABC is considering a major change in its capital structure. It has three options: Option 1: Issue $1 billion in new stock and repurchase half of its outstanding debt. This will make it an AAA-rated firm (AAA rated debt is yielding 11% in the marketplace). Option 2: Issue $1 billion in new debt and buy back stock. This will drop its rating to A-. (A-rated debt is yielding 13% in the marketplace). Option 3: Issue $3 billion in new debt and buy back stock. This will drop its rating to CCC (CCC rated debt is yielding 18% in the marketplace). a) What is the cost of capital under each option and what decision you would take? b) How would your analysis change (it at all) if the money under the three options were used to take new investments (instead of repurchasing debt or equity)? c) What other consideration (besides minimizing the cost of capital) would you bring to bear on your decision?

Explanation / Answer

Current Cost of Capital Debt 12%*(1-0.30)= 8.40% MPS/EPS=10 Equity 80/EPS=10 Price/Earnings= Market Price/EPS =10 EPS= 8 So, EPS= 80/10=8 Market Return=( 4+8)/80=0.15 or 15% Calculating Cost of Equity as per CAPM Ke= RFR+Beta*(Market Return-RFR)    =0.08+1.2*(0.15-0.08)= 0.164 16.40% Type of Capital Market Value Weight Cost Weight*cost Debt 2000000000 0.3333 0.084 0.028 Equity 4000000000 0.6667 0.164 0.10933 6000000000 1 0.13733 WACC 13.73% a. Type of Capital Market Value Weight Cost Weight*cost Option 1 Equity 5000000000 0.8333 0.164 0.136667 Debt 1000000000 0.1667 0.077 0.01283 6000000000 1 0.14950 WACC 14.95% Option 2 Equity 3000000000 0.5000 0.164 0.082 Debt 3000000000 0.5000 0.091 0.04550 6000000000 1 0.12750 WACC 12.75% Option 3 Equity 1000000000 0.1667 0.164 0.027333 Debt 5000000000 0.8333 0.126 0.10500 6000000000 1 0.13233 WACC 13.23% Option 2 50% Equity & 50% debt has least cost of capital of 12.75% b. All new investments Type of Capital Market Value Weight Cost Weight*cost Debt 2000000000 0.2857 0.084 0.024 Equity 4000000000 0.5714 0.164 0.09371 New Stock 1000000000 0.1429 0.164 0.11771 7000000000 1 0.235429 WACC 23.54% Option 2 Debt 2000000000 0.2857 0.084 0.024 Equity 4000000000 0.5714 0.164 0.09371 New Debt 1000000000 0.1429 0.091 0.11771 7000000000 1 0.235429 WACC 23.54% Option 3 Debt 2000000000 0.2222 0.084 0.018667 Equity 4000000000 0.4444 0.164 0.07289 New Debt 3000000000 0.3333 0.126 0.09156 9000000000 1 0.183111 WACC 18.31% c)Cost of acquisition of debt funds ,their availability,interest rates and interest commitments are other factors that are to be considered.

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