Capital Structure Analysis Pettit Printing Company has a total market value of $
ID: 2791133 • Letter: C
Question
Capital Structure Analysis Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company's EBIT is $10.85 million, and its tax rate is 20%. Pettit can change its capital structure by either increasing its debt to 60% (based on market values) or decreasing it to 40%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12% coupon. If it decides to decrease its leverage, it will call its old bonds and replace them with new 896 coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change. The firm pays out all earnings as dividends, hence, its stock is a zero growth stock. Its current cost of equity, rs is 14%. If it increases leverage, rs will be 16%. If it decreases leverage, rs will be 13%. Present situation (50% debt) What is the firm's WACC? Round your answer to three decimal places. What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places. million 60% debt: What is the firm's WACC? Round your answer to two decimal places. What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places. million 40% debt: What is the firm's WACC? Round your answer to two decimal places What is the total corporate value? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to three decimal places. millionExplanation / Answer
Present Situation - 50% debt, 50% equity
WACC = Cost of equity x weight of equity + Cost of debt x (1 - tax rate) x weight of debt
Or, WACC = 14% x 0.5 + 10% x (1 - 0.20) x 0.5 = 11%
Total corporate value = Operaitng free cash flows of firm x (1 - tax rate) / WACC
Now, operating free cash flows of firm are cash flows generated by operations which is equal to EBIT in our current case. So, we have -
Total corporate value = $10.85 million x (1 - 0.20) / 0.11 = $78.909 million
60% debt, 40% equity
Cost of equity = 16%, Cost debt = 12%
WACC = 16% x 0.40 + 12% x (1 - 0.20) x 0.60 = 12.16%
Total Corporate value = $10.85 million x (1 - 0.20) / 0.1216 = $71.382 million
40% debt, 60% equity
Cost of equity = 13%, Cost of debt = 8%
WACC = 13% x 0.60 + 8% x (1 - 0.20) x 0.40 = 10.36%
Total corporate value = $10.85 million x (1 - 0.20) / 0.1036 = $83.784 million