1. EBIT = $300 for the next five years, after which the company will go out of b

Question

1. EBIT = $300 for the next five years, after which the company will go out of business and be worth zero. rRF = 3% Expected return on the market = 11% Stock’s beta () = 0.9 The firm’s corporate tax rate is 28%. The firm’s investment bankers say that it could sell new debt at a 5.5% yield. The company’s market-valued balance sheet is financed one-third with debt and two-thirds with equity. A) Compute the market value of the firm’s stock. B) What would be the stock’s beta () if the balance sheet included a different proportion of debt and equity: say wd = .5 and ws = .5? How would that change the firm’s WACC? How would the leverage change affect the firm’s market value?

Explanation / Answer

Proportion of Debt=1/3

Proportion of Equity=2/3

2)

Stock's beta or Beta levered=beta unlevered*(1+(1-t)*D/E)=0.9*(1+(1-28%)*0.5)=1.224

Cost of equity=3%+1.224*(11%-3%)=12.792%

WACC=12.792%*2/3+5.5%*(1-28%)*1/3=9.848%

Enterprise Value=300*(1-28%)/1.09848+300*(1-28%)/1.09848^2+300*(1-28%)/1.09848^3+300*(1-28%)/1.09848^4+300*(1-28%)/1.09848^5=822

1)

So, Equity=2/3*822=$548

3)

Stock's beta or Beta levered=beta unlevered*(1+(1-t)*D/E)=0.9*(1+(1-28%)*1)=1.548

Cost of equity=3%+1.548*(11%-3%)=15.384%

WACC=15.384%*1/2+5.5%*(1-28%)*1/2=9.672%

Enterprise Value=300*(1-28%)/1.09672+300*(1-28%)/1.09672^2+300*(1-28%)/1.09672^3+300*(1-28%)/1.09672^4+300*(1-28%)/1.09672^5=$825.7174

Equity=825.7174/2=$412.86

Debt=$412.86

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