Question

Rig Real Estate Ltd currently uses no debt. EBIT is expected to be $9000 forever, and the cost of capital is currently 15 per cent. The corporate tax rate is 30 per cent. a. What is the market value of Rig Real Estate? b. Suppose Rig floats a $30 000 debt issue and uses the proceeds to reduce share capital. The interest rate is 10 per cent. What is the new value of the business? What is the new value of the equity? c. What is the cost of equity after the debt issue? What is the weighted average cost of capital? What are the implications for capital structure?

Answer 1

Ans a) Market value of firm = 9000 * (1-taxrate) / cost of capital

= 9000 * .7 / .15

= $42000

Ans b) Value of leavered firm = V_u + t * Debt = 42000 + .3 * 30000

= $ 51000

Debt = $30000 & Equity = $21000

Ans c) Cost of equity after recapitalization = R_u + (R_u - R_d) * (D/E) * (1 - t)

= .15 + (.15 - .1) * 1.43 * .7

= .20005 (20%)

WACC = 30000/51000 * .7 * .1 + 21000/51000 * .2

= 12.35%

After adding debt WACC reduced to 12.35% from 15% and cost of equity increases from 15% to 20 %