Question

# Meyer & Co. expects its EBIT to be \$159,000 every year forever. The firm can borrow...

 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.)

a. The value of the unlevered firm is:

V = EBIT(1 – TC) / R0

V = \$159,000(1 – 0.24) / 0.15

V = \$805,600

The value of the levered firm is:

V = VU+ TCB

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:

RS = R0 + (R – RB)(B/S)(1 – TC)

RS = 0.15 + (0.15 – 0.08)(\$201,000 / \$652,840)(1 – 0.24)

RS = 0.1664 or 16.64%

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

WACC = (S/V)RS + (B/V)RB(1 – TC)

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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