Cops & Co. expects its EBIT to be $60,000 every year forever. Cops currently has
ID: 2751960 • Letter: C
Question
Cops & Co. expects its EBIT to be $60,000 every year forever. Cops currently has no debt and its cost of equity is 22 percent. The firm is considering issuing new par bonds and uses the proceeds of the new debt to repurchase equity. The firm can borrow at 13 percent and tax rate is 35 percent.
(a) What is the value of the firm?
(b) What will the value be if Cops borrows $25,000 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) What is the value of the firm?
value of the firm = EBIT*(1-tax rate)/Cost of Equity
value of the firm = 60000*(1-35%)/22%
value of the firm = $ 177,272.73
(b) What will the value be if Cops borrows $25,000 and uses the proceeds to repurchase shares?
Value = value of the Unlevered firm + Debt*tax rate
Value = 177272.73 + 25000*35%
Value = $ 186022.73
(c) What is the cost of equity after recapitalization?
cost of equity = Unlevered Cost of Equity + D/E *(Unlevered Cost of Equity - Cost of Debt)*(1-tax rate)
cost of equity = 22% + 25000/(186022.73-25000) * (22% -13%)*(1-35%)
cost of equity = 22.91%
(d) What is the weighted average cost of capital (WACC) after recapitalization?
weighted average cost of capital (WACC) = Weight of Equity * cost of Equity + Weight of debt*After tax cost of debt
weighted average cost of capital (WACC) = (186022.73-25000)/186022.73 * 22.91% + 25000/186022.73*13%*(1-35%)
weighted average cost of capital (WACC) = 20.97%