Firebird, Inc, is investigating the (possible) purchases if Firm A. Firebird, In

Question

Firebird, Inc, is investigating the (possible) purchases if Firm A. Firebird, Inc. and Firm A are considered to be similar in nature and risk. Firebird's current and target capital structure includes 50% Debt, 15% Preferred Stock and 35% Common Stock. Firebird's bonds pay annual interest at a rate of 15%. The required rate of return by Preferred Stockholders is 20%. The cost of equity for Common Stock is 24%, and the After-Tax Rate is 80% For an indefinite period of time, Firm A is expected to have annual retention of $30, 000 on a fiscal year, and Firebird proposes to acquire Firm-A one day after year-end (i.e.: the first day of next fiscal year). Based upon the aforementioned information, please find the maximum price that Firebird, Inc. would pay to acquire Firm A.

Explanation / Answer

Weighted avg cost of capital ( Waac)

Cost of debt = ( 15*80% ( 1-20% tax ))* 0.5 (Weights)

cost of Preference share capital = ( 20%*0.15( weight)

Cost of Equity = (24%*0.35)

Waac = 17.4 %

Retained earning = $ 30000

Total earning = $ 30000*100/30

= $ 100000

EBIT = $ 100000*100/80

=$ 125000

Value of firm = $ 125000/0.174

= $ 718391 is maximum price that firebird will pay to accuquire firm A

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