Question

Spam Corp. is financed entirely by common stock and has a beta of 1.60. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price-earnings ratio of 7.60 and a cost of equity of 13.16%. The company’s stock is selling for $28. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with an interest rate of 6%. The company is exempt from corporate income taxes. Assume MM are correct.

a. Calculate the cost of equity after the refinancing. (Enter your answer as a percent rounded to 2 decimal places.)

Cost of equity %

b. Calculate the overall cost of capital (WACC) after the refinancing. (Enter your answer as a percent rounded to 2 decimal places.)

Cost of capital %

c. Calculate the price-earnings ratio after the refinancing. (Round your answer to 2 decimal places.)

Price-earnings ratio

d. Calculate the stock price after the refinancing. (Round your answer to the nearest whole number.)

Stock price $

e. Calculate the stock’s beta after the refinancing. (Round your answer to 1 decimal place.)

Stock's beta

Answer 1

a). According to Modigliani and Miller, Proposition II,

re(Levered) = re(Unlevered) + [DE*{re(Unlevered) - rd}]

= 0.1316 + [1*(0.1316 - 0.06)] = 0.1316 + 0.0716 = 0.2032, or 20.32%

b). WACC = [re*we] + [rd*wd]

= [20.32%*0.5] + [6%*0.5] = 10.16% + 3% = 13.16%

c). Since the cost of capital is the same (13.16%) and future cash flows are the same, the stock price will be the same and price to earnings ratio is the same.

price to earnings ratio = 7.60

d). As argued above, the price is the same.

Price = $28

e). βL = βU*[1 + {(1 - T)*D/E}]

= 1.60*[1 + 1] = 1.60*2 = 3.20