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.
PLEASE SHOW ALL WORK:

(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

1a) The value of an Unlevered firm is:

EBIT(1-Tax Rate)/Required Rate of Return

=4000(1-0.30)/0.15

=$ 18,666.67

1b) The value of the firm after the restructuring is:

                EBIT(1-Tax Rate)/Required Rate of Return+Debt (Tax Rate)

=4000(1-0.30)/0.15+8800(0.30)

= $ 21,306.37

1c) We already know the value of the firm after restricting is $ 21,306.37

       Value of Equity After Restructuring= 21,306.37-8,8800=$ 12,506.67

      Cost of Equity After Restructuring=0.15+(0.15-0.10)(8800/12506.67)=0.1851=18.51%

1d) WACC

                   =0.10(1-0.30)(8800/21306.37)+0.1851(12506.67/21306.37)

                 =13.76%

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