Question

Jim Campbell is founder and CEO of​ OpenStart, an innovative software company. The company is​ all-equity financed, with 100 million shares outstanding. The shares are trading at a price of $1. Rosenzweig currently owns 20 million shares. There are two possible states in one year. Either the new version of their software is a​ hit, and the company will be worth $160​million, or it will be a​ disappointment, in which case the value of the company will drop to $75 million. The current risk-free rate is 2%. Rosenzweig is considering taking the company private by repurchasing the rest of the outstanding equity by issuing debt due in one year. Assume the debt is​ zero-coupon and will pay its face value in one year.

a. What is the market value of the new debt that must be​ issued?

b. Suppose OpenStart had​ risk-free debt with a face value of $75 million. What would be the value of its debt and levered equity​ today?

c. What fraction of the levered equity in ​(b​)would you need to combine with the​ risk-free debt in ​(b​) to raise the amount in (a)​?

d. What are the payoffs of the portfolio in ​(c​)? What face value of risky debt would have the same​ payoffs?

e. What is the yield on the new debt that will be required to take the company​ private?

f. If the two outcomes are equally​ likely, what is​ OpenStart's current WACC​ (before the​ transaction)?  

g. What is​ OpenStart's debt and equity cost of capital after the​ transaction? Show that the WACC is unchanged by the new leverage.

Answer 1