Marthas Grapvines Inc. is 100% equity finaning and has an expected perpetual EBI

Question

Marthas Grapvines Inc. is 100% equity finaning and has an expected perpetual EBIT = $4,000. The firm’s cost of equity is 15%. The firm is considering issuing $8,800 in new par bonds to add financial leverage to the firm. The proceeds of the debt will be used to repurchase equity. The cost of debt is 10% and the tax rate is 30 percent.

(a) What is the value of the firm under current capital structure of 100% equity financing?
(b) What will the value be if Marthas Grapvines Inc. borrows $8,800 and uses the proceeds to repurchase shares?
(c) What is the cost of equity after recapitalization?
(d) What is the weighted average cost of capital (WACC) after recapitalization?

Explanation / Answer

a) Value of firm = EBIT x (1 - tax) / Cost of equity = 4000 x (1 - 30%) / 15% = $18,666.67

b) Value of firm = Unlevered value + Debt x Tax Rate = 18,666.67 + 8,800 x 30% = 21,306.67

Debt = 8,800, Equity = 21,306.67 - 8,800 = 12,506.67

c) Cost of equity = ru + (1 - tax) x D/E x (ru - rd) = 15% + (1 - 30%) x 8,800 / 12,506.67 x (15% - 10%)

= 17.46%

d) WACC = we x re + wd x rd x (1 - tax)

= 12,506.67 / 21,306.67 x 17.46% + 8,800 / 21,306.67 x 10% x (1 - 30%)

= 13.14%

Another way, WACC = EBIT x (1 - tax) / Firm Value = 4,000 x (1 - 30%) / 21,306.67 = 13.14%

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