Question

Currently, Network Solutions Limited does not use any financial leverage, and its total capital is $100 million with a share price of $1 each. The company is considering refinancing by issuing $20 million of debt, which pays an annual coupon rate of 9.0% and using that money to buy back 20% of the company’s ordinary shares. NetworkSolutions Limited’s earnings before interest and tax (EBIT) are expected to be constant for the foreseeable future, and all profits are paid out as dividends. The weighted average cost of capital is 12%.

Required:

1. (a) Using the assumptions of Modigliani and Miller, if the company goes ahead with the refinancing option, calculate the cost of equity capital.

   (Assumption: the company operates in a no-tax environment).

2. (b) Using the assumptions of Modigliani and Miller, if the company goes ahead with the proposal, calculate the following:
   (Assumption: The company tax rate is 28%)

3. The value of the company

4. The debt to equity ratio of the company

5. The new cost of equity capital

6. The revised weighted average cost of capital.

(c) Explain how a company’s capital structure decisions affect the level and the volatility of the company’s earnings per share (EPS).

Answer 1

a). Ke (cost of levered equity) = Ku + (Ku - Kd)*D/E where

Ku (cost of unlevered equity) = 12%; Kd (cost of debt) = 9%; D/E = 20/80 = 0.25

Ke = 12% + (12%-9%)*0.25 = 12.75%

b). Value of levered firm = value of unlevered firm + debt tax shield

= 100 + (28%*20) = 105.6 million

Debt to equity ratio (D/E) = Debt value/Levered equity value = Debt value/(Value of levered firm - debt value)

= 20/(105.6 -20) = 0.2336

New cost of equity (Ke) = Ku + (Ku-Kd)*D/E*(1-Tax rate)

= 12% + (12%-9%)*0.2336*(1-28%) = 21.85%

WACC = (debt ratio*cost of debt*(1-Tax rate)) + (equity ratio*cost of equity)

Equity ratio = 1/(1+D/E) = 0.81061; Debt ratio = 1-equity ratio = 1-0.81061 = 0.18939

WACC = (0.18939*9%*(1-28%)) + (0.81061*21.85%) = 18.94%