ACB Inc. is examining its capital structure with the intent of arriving at an op
ID: 2750640 • Letter: A
Question
ACB Inc. is examining its capital structure with the intent of arriving at an optimal debt ratio. It currently has no debt and has a beta of 1.3. The T-bill rate is 8% and the T-Bond rate is 9.5%. Your research indicates that the debt rating will be as follows at different debt levels:
D/(D+E)
Rating
Interest rate
0%
AAA
10%
10%
AA
10.5%
20%
A
11%
30%
BBB
12%
40%
BB
13%
50%
B
14%
60%
CCC
16%
70%
CC
18%
80%
C
20%
90%
D
25%
The firm currently has 2 million shares outstanding at $30 per share, and the tax rate is 40%.
What is the firm’s optimal debt ratio?
Assuming that the firm restructures and purchases stock with debt, what will the value of
the stock be after the restructuring?
Explanation / Answer
As Per CAPM
Cost of Equity = Risk free rate + (Market Rate- Risk free rate )*beta
Cost of Equity with no debt = 8 + (9.5-8)*1.3
Cost of Equity with no debt = 9.95%
WACC = (1-Debt Ratio)*Cost of Equity + Debt ratio*After tax cost of debt
Minimum WACC = 9.476%
Firm’s optimal debt ratio = Debt Ratio at Minimum WACC
Firm’s optimal debt ratio = 30%
2)
Assuming that the firm restructures and purchases stock with debt, what will the value of the stock be after the restructuring?
Value of firm before restructuring = 30*2 = $ 60 Million
Expected EBIT = Value of firm before restructuring * WACC before restructuring
Expected EBIT = 60*9.95%
Expected EBIT = $ 5.97 Million
Value of Firm after restructuring = Expected EBIT/NEW WACC
Value of Firm after restructuring = 5.97/9.476%
Value of Firm after restructuring = $ 63 Million
Value of Debt = 63 *30% = $ 18.90 Million
No of Stock Buyback = 18.90/30 = 0.63 Million
No of Stock outstanding = 2 - 0.63 = 1.37 million
Value of Equity = Value of Firm after restructuring *(1-debt ratio)
Value of Equity = 63*(1-30%)
Value of Equity = $ 44.10 Million
value of the stock be after the restructuring = Value of Equity/ No of Stock outstanding
value of the stock be after the restructuring = 44.10/1.37
value of the stock be after the restructuring = $ 32.19
D/(D+E) Rating Interest rate Beta Cost of Equity WACC [a] [b] [c] [d = 1.30 *(1 + (1-0.40)*a/(1-a)] [e = 8% + (9.5%-8%)*beta] [f = (1-a)*e + a * c*(1-40%)] 0% AAA 10% 1.30 9.950% 9.950% 10% AA 10.50% 1.39 10.080% 9.702% 20% A 11% 1.50 10.243% 9.514% 30% BBB 12% 1.63 10.451% 9.476% 40% BB 13% 1.82 10.730% 9.558% 50% B 14% 2.08 11.120% 9.760% 60% CCC 16% 2.47 11.705% 10.442% 70% CC 18% 3.12 12.680% 11.364% 80% C 20% 4.42 14.630% 12.526% 90% D 25% 8.32 20.480% 15.548%Related Questions
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