Question

Meyer & Co. expects its EBIT to be $159,000 every year forever. The firm can borrow at 8 percent. The company currently has no debt, and its cost of equity is 15 percent and the tax rate is 24 percent. The company borrows $201,000 and uses the proceeds to repurchase shares. |

a. |
What is the cost of equity after recapitalization? |

b. |
What is the WACC? (Do not round intermediate
calculations and enter your answer as a percent rounded to 2
decimal places, e.g., 32.16.) |

Answer #1

a. The value of the unlevered firm is:

V = EBIT(1 – T_{C}) / R_{0}

V = $159,000(1 – 0.24) / 0.15

V = $805,600

The value of the levered firm is:

V = V_{U}+ T_{C}B

V = $805,600 + 0.24($201,000)

V = $853,840

We can find the cost of equity using M&M Proposition II with taxes. First, we need to find the market value of equity, which is:

V = B + S

$853,840 = $201,000 + S

S = $652,840

Now we can find the cost of equity, which is:

R_{S} = R_{0} + (R – R_{B})(B/S)(1 –
T_{C})

R_{S} = 0.15 + (0.15 – 0.08)($201,000 / $652,840)(1 –
0.24)

R_{S} = 0.1664 or **16.64%**

b. Using this cost of equity, the WACC for the firm after recapitalization is:

WACC = (S/V)R_{S} + (B/V)R_{B}(1 –
T_{C})

WACC = 0.1664[($853,840 – $201,000) / $853,840] + 0.08(1 – 0.24)($201,000 / $853,840)

WACC = 0.1415 or **14.15%**

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