Bruce & Co. expects its EBIT to be $61,000 every year forever. The company can b

Question

Bruce & Co. expects its EBIT to be $61,000 every year forever. The company can borrow at 7 percent. The company currently has no debt, its cost of equity is 14 percent, and the tax rate is 35 percent. The company borrows $148,000 and uses the proceeds to repurchase shares.

What is the cost of equity after recapitalization? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What is the company's WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What is the cost of equity after recapitalization? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

1. Vu = EBIT*(1-tax rate)/cost of equity = $61,000*(1-0.35)/0.14 = $283,214.29

VL = Vu+tax rate*(amount being borrowed) = $283,214.29+0.35*148,000 = $335,014.29

Cost of equity = cost before recapitalization + (cost before recpaitalization-borrwoing rate)*(amount being borrowed/Vl-amount being borowed)*(1-tax rate)

= 14%+(14%-7%)*(148,000/335014.29-148,000)*(1-35%)

= 14%+0.07*(0.79)*0.65

= 14%+3.60%

17.60%

2. WACC = cost of equity after recapitalization*(Vl-amount being borrowed)/Vl + borrowing rate*(amount being borrowed/Vl)*(1-tax rate)

= 17.60%*(335014.29-148000)/335014.29 + 7%*(148000/335014.29)*(1-35%)

= 17.6%*0.79+7%*0.29

= 13.93%+2.01%

= 15.94%

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