Shearer Sales Consulting (SSC) has 20 million shares of stock outstanding that t

Question

Shearer Sales Consulting (SSC) has 20 million shares of stock outstanding that trade at $50. The risk-free interest rate is 4% and the market risk premium is 7.6%. This stock has a beta of 2.16. SCC also has $750 million in 11% bonds outstanding and the company has a 34% tax rate. Show all calculations for each of your answers to earn full credit.

Part 1: a) Calculate the firm’s market capitalization, and then calculate the enterprise value.

b) Use the CAPM formula to determine the firm’s cost of equity, and c) utilize this information to calculate SCC’s weighted average cost of capital.

Part 2: a) Assume that SCC issues $100 million in bonds to buy back $100 million in common stock in order to recapitalize the firm. What is Shearer Consulting’s new WACC? b) Finally, discuss why there is a change in WACC and explain the impact of the components of capital structure on a company’s cost of capital.

Explanation / Answer

Solution : part-1 [a] Market capitalisation : = no. of shares * market value = 20 million * 50 = 1000 million Enterprise value : = M-capitalisation + total debt = 1000 M + 750 M = 1750 million [b] Ke = Rf + (Rm- Rf)*Bs = 4 % + { 7.6% * 2.16} = 20.416% [c] WACC In million Weight cost wiight * cost (Ke & Kd) EQUITY 1000 0.571429 20.416% 0.11666286 DEBT 750 0.428571 2.64% 0.01131429 Total 1750 0.12797714 Note : calculation of Kd Kd = Rf *(1-tax) = 4% * (1-0.34) = 2.64% So K-o = 12.80 Approx. Part-2 [a] WACC In million Weight cost wiight * cost (Ke & Kd) EQUITY 900 0.514286 20.416% 0.10499657 DEBT 850 0.485714 2.64% 0.01282286 Total 1750 0.11781943 So K-o = 11.78% [b] K-o has changed due change in capital structure. As debt increases and equity decreases Debt having low cost so its increase will reduces the WACC while Reduction in equity also reduced WACC as higher cost of equity will be cuted down due to buyback

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