Question

1. Suppose an unleveraged company in a world without taxes has $250 million in assets.

1. With 8 million outstanding shares of stock, what is the price of each share?

1. Suppose the expected EBIT for this company is $27.5 million per year. Calculate each of the following:

1. • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

1. Now, suppose you wish to shift the capital structure of this company, issuing $65 million in bonds and using the proceeds to buy up shares of stock. How many shares will be outstanding after this shift? (show)

1. If the interest rate on your debt is 6.2%, what is your expected EBT? (show)

1. Calculate each of the following for the newly leveraged firm:

1. • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

1. Now, take the same firm, but put it in an environment where there is a 21% tax rate.

1. What is the value of the unleveraged firm in the world with taxes and what will be the price of each equity share?

1. Calculate each of the following for the unleveraged firm:

1. • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

1. What is the value of the leveraged firm in the world with taxes and what will be the price of each equity share?

1. Calculate each of the following for the leveraged firm:

1. • ROA
   • ROE
   • EPS
   • WACC
   • Cost of Equity

Answer 1

It is an unleveraged company without any taxes. So EBIT = Earnings available for equity shareholders because Interest and taxes will be 0.

Total Aseets will also be equal to Equity because there is no debt.

Thus EBIT = $27.5 Million Assets = $ 250 Million, No of shares outstanding = 8 million

1) ROA = EBIT / Total Assets * 100 = 27.5 / 250 *100 = 11%

2) ROE = EBIT / Equity*100 = 27.50 / 250 *100 = 11% (since total assets = equity as no leverage)

ROE is also known as Ke or Cost of Equity

3) EPS = EBIT / No of Shares = 27.50 / 8 = $ 3.4375

4) WACC = Kd{(Debt / (Debt+Equity)} + Ke{Equity/ (Debt + Equity)}

since Debt = 0   WACC = Ke(Equity/Equity) = Ke = 11%

(5) Cost of Equity = 11%