6. Firm ABC starts as all-equity financed and the market value of its net worth

Question

6. Firm ABC starts as all-equity financed and the market value of its net worth is $1,000,000 (P/B of 1.25). The beta for the stocks of this firm is 1.2 when the market return is 8% and the risk-free rate is 3%. When the firm starts to grow, it needs to issue bonds at par value of $300,000 that pay 5% of interest annually in perpetuity. The tax rate of ABC is 30%. a. What is the cost of capital for the firm and for the shareholders of ABC before the debt issue? b. What would be the cost of capital for the shareholders after the debt issue? Explain the reason for the difference with your answer in a) c. What would be the cost of capital for ABC after the debt issue?

Explanation / Answer

Cost of equity = rf + beta * (rm -rf)

= 3%+ 1.2*(8%-3%)

= 6.6%

Unlevered cost of equity =6.6%

Debt = 300000

equity=1000000-300000 = 700000

Cost of capital of levered Equity = Unlevered cost of equity + Debt/equity *(Unlev. cost o equity-cost of debt)*(1-tax)

=6.6% + 300000/700000 *(6.6%-5%)*(1-0.30)

Cost of levered equity = 7.08%

With the introduction of debt the cost of equity for ABC increases i.e cost of levered equity is more than cost of unlevered equity.

As debt is risky, increase in level of debt increases the overall cost of equity of ABC, Investors demand a higher payoff from shares of risky company.

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