Question

During an analysis of the capital structure of ABC Inc. it has been determined that the optimal debt (debt to capital ratio or DCR) should be targeted at 50%. Given the following information answer these two fundamental questions regarding its capital structure now and after the proposed changes: The market value if its current debt is $500 million, the current share price is $10 and 1 million shares are outstanding at this time. It's marginal tax rate is 40% and the beta for the firm is 1.5. Their debt is A rated and it is determined that their bond rating will drop at the optimal DCR of 50% and an additional .250 spread will be added to the debt service at that time. It is given that the rfr is 2.5%, the mrp is 6.5%, the bond spread on A ratings is .750%. (Assume market debt rate is rfr + spreads) 1) Estimate the current cost of capital (WACC) for ABC Inc. 2) At the Optimal DCR of 50%, what is the new WACC? For 10 points of extra credit: 3) If you were given the information that ABC Inc delivered after tax cash flow of $.75/share and that they were anticipating a steady growth rate of 4% for the near future, what would you value the firm at under the optimal DCR? How does that compare with its current share price?

Answer 1

Current Market value of equity (E) = $10 *1 million = $ 10 million

Current Debt Value (D) = $500 million

D/E = 500/10 = 50

This is way too much of Debt. I think something is wrong here either the share price or the shares outstanding or the market value of Debt. Companies with such high D/E ratios are rare to find.

D+E = V

By CAPM --> Cost of equity = 2.5 + 1.5*6.5 = 12.25%

1) Current WACC = (D/V)*(1-Tax rate)*(2.5+ 0.75) + (E/V)*12.25 = 2.1519%

2)

Beta (current) = 1.5

Beta (unlevered) = Beta(Current) / ( 1 + (1-Tax rate)*D/E ) = 1.5/31

Beta (New) = (1.5/31)*(1 + 0.6*0.5) = 0.0629

By CAPM --> Cost of equity = 2.5 + 0.0629*6.5 = 2.9088%

WACC = 0.5*0.6*3.5 + 0.5*2.9088 = 2.5044%

Please check with the numbers again and get back to me. I think something is wrong in the problem.

3) Value = 0.75*1.04/(0.029088 -0.04) ----- WRONG !!!!