Question

Meyer & Co. expects its EBIT to be $139,000 every year forever. The firm can borrow at 7 percent. The company currently has no debt, and its cost of equity is 10 percent and the tax rate is 24 percent. The company borrows $186,000 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

VU = EBIT(1 - TC)/RU (RU= RE; when no debt)

VU = $139,000(1 - 0.24)/0.10 = $105,640/0.10 = $1,056,400

VL = VU + TC*D

VL = $1,056,400 + 0.24($186,000) = $1,056,400 + $44,640 = $1,101,040

a). We can find the cost of equity using M&M Proposition II with taxes.

RE = RU + (RU - RD)(D/E)(1 - t)

= 0.10 + [(0.10 - 0.07){$186,000/($1,101,040 - $186,000)}(1 - 0.24)]

= 0.10 + [0.03 x 0.2033 x 0.76] = 0.10 + 0.0046 = 0.1046, or 10.46%

b). WACC = [(E/V)RE] + [(D/V)RD(1 - tC)]

= [{($1,101,040 - $186,000) / $1,101,040} x 10.46%] +

[($186,000/$1,101,040) x 7% x (1 - 0.24)]

= 8.70% + 0.90 = 9.59%