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? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
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) / R₀

V = $159,000(1 – 0.24) / 0.15

V = $805,600

The value of the levered firm is:

V = V_U+ T_CB

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 = R₀ + (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%