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 $11.16 million, and its tax rate is 15%. Pettit can change its capital structure either by increasing its debt to 70% (based on market values) or decreasing it to 30%. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 13% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 9% 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.

70% 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.

30% 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.

Answer 1

Formulas used:

WACC of a company's capital structure = Wd*Kd*(1-tax rate) + We*Ke, where:

• Wd = weight of debt in capital structure
• Kd = pre-tax cost of debt
• We = weight of equity in capital structure
• Ke = cost of equity

Value of a company = EBIT*(1-tax rate) / WACC

Solution:

Current scenario: 50% debt

• WACC = 50%*10%*(1-15%) + 50%*14% = 11.250%
• Value of company = [11.16*(1-0.15)]/0.11250 = $84.320 mn

Scenario 1: 70% debt, 30% equity

• WACC = 70%*13%*(1-0.15) + 30%*16% = 12.535%
• Value of company = [11.16*(1-0.15)]/0.12.535 = $75.676 mn

Scenario 2: 30% debt, 70% equity

WACC = 30%*9%*(1-15%) + 70%*13% = 11.395%

Value of company = [11.16*(1-.015)]/0.11395 = $83.247 mn

Kindly give a thumbs up!!