Question

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current unlevered beta is 0.5, and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00. The firm is considering moving to a capital structure that is comprised of 40 percent debt and 60 percent equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7 percent. The risk free rate is 6 percent and the market risk premium is 5 percent.

What would be its new total market value of debt and total market value of equity respectively?

Answer 1

EBIT = $100,000

Unlevered beta = 0.5

levered beta = unlevered beta * ( 1 + (1 - tax rate) * (debt / equity) )

= 0.5 * ( 1 + (1 - 0.40) * ( 0.40 / 0.60)

Levered beta = 0.7

New cost of debt = 7%

New cost of equity = Rf + beta * market risk premium

= 6% + 0.7 * 5%

Cost of equity = 9.5%

New WACC = Cost of debt * Weight of debt * (1 - tax rate) + Cost of equity * weight of equity

= 7% * 0.40 * (1- 0.40) + 9.5% * 0.60

New WACC = 7.38%

Value of firms = EBIT (1 - tax rate) / WACC

= 100000 ( 1- 0.40) / 7.38%

= 60,000 / 0.0738

Value of firm = $ 813,008.13

Debt value = Value of firm * 0.40 = $ 325,203.252

Equity value = value of firm - value of debt = $ 813,008.13 - 325,203.252 = 487,804.878