Meyer & Co. expects its EBIT to be $105,000 every year forever. The firm can bor
ID: 2720277 • Letter: M
Question
Meyer & Co. expects its EBIT to be $105,000 every year forever. The firm can borrow at 7 percent. Meyer currently has no debt, and its cost of equity is 13 percent and the tax rate is 35 percent. The company borrows $136,000 and uses the proceeds to repurchase shares.
What is the cost of equity after recapitalization?
What is the WACC?
Meyer & Co. expects its EBIT to be $105,000 every year forever. The firm can borrow at 7 percent. Meyer currently has no debt, and its cost of equity is 13 percent and the tax rate is 35 percent. The company borrows $136,000 and uses the proceeds to repurchase shares.
Explanation / Answer
To answer both the parts, we need to calculate the value of unlevered firm and levered firm. These values can be calculated as follows:
Value of Unlevered Firm = EBIT*(1-Tax Rate)/Cost of Equity
Value of Levered Firm = Value of Unlevered Firm + Value of Debt*Tax Rate
___________
Value of Unlevered Firm = 105,000*(1-35%)/13% = $525,000
Value of Levered Firm = 525,000 + 136,000*35% = $572,600
___________
Part A)
The revised cost of equity after recapitalization can be calculated as follows:
Cost of Equity after Recapitalization = Current Cost of Equity + (Current Cost of Equity - Cost of Debt)*(Debt/Revised Equity)*(1-Tax Rate)
___________
Cost of Equity after Recapitalization = 13 + (13 - 7)*(136,000/(572,600 - 136,000))*(1-35%) = 14.21%
___________
Part B)
The WACC can be calculated as follows;
WACC = Cost of Equity after Recapitalization*Value of Equity/Value of the Levered Firm + Cost of Debt*Value of Debt/Value of the Levered Firm*(1-Tax Rate)
___________
Using the values calculated above and information provided in the question, we get,
WACC = 14.21%*(572,600 - 136,000)/572,600 + 7%*(136,000)/572,600*(1-35%) = 11.92%