Question

You are working for The Good, The Bad and the Ugly Inc. in the country called Wild Wild West which does not have any corporate taxes. Currently the company has 30% debt, 70% equity capital structure. The company has 500,000 shares of common stock outstanding. Suppose the required rate of return on the debt of the company is 9.1% per year. The current EBIT of the company is $2 million and the EBIT of the company is expected to grow at 3% per year forever. The cost of equity under the current capital structure of the company is 15%. Managers of the company wants to change the capital structure of the firm and finance 100% of the firm’s assets with equity. The company is going to have its shareholders meeting next week to discuss this change in its capital structure. In order to get ready for this meeting, your boss asked you to do some analysis of the company.

1.Calculate the value of the firm with its 30% debt, 70% equity capital structure.

2.The company is going to issue some additional shares and use the money to buy back its bonds. Determine the number of new shares the company needs to issue to achieve its desired 100% equity capital structure.

3.Determine the EBIT that would make the company indifferent between 30% debt-70% equity and 100% equity financing.  

4.Given the break-even EBIT you calculated in part (c) of this question and the EBIT the company currently has, indicate and briefly justify the capital structure that should be preferred by the firm.

5.Suppose the shareholders decided to have the all equity capital structure in the shareholders meeting.

6.Today is exactly three years after that meeting. The country Wild Wild West decides to have a corporate tax rate of 25% starting from today. Calculate the value of The Good, The Bad and the Ugly Inc., an all equity financed company, when there is a 25% corporate tax rate in the country.

7.Suppose managers of The Good, The Bad and the Ugly Inc. decides to change the capital structure of the company again. Managers want to have 30% debt-70% equity financing. The company can issue the required amount of debt at 10% interest rate per year. Determine the amount of money the company needs to borrow to achieve this 30% debt-70% equity capital structure. Please remember that the value of the firm also changes with the amount of money borrowed.   

8.Given the amount of borrowing company needs to have in part (f) of this question, calculate the value of the The Good, The Bad and the Ugly Inc. and value of its equity with this new capital structure when there is a 25% corporate tax rate in the country.

9.Briefly explain the reason for the difference in the value of the firm you calculated in parts (e) and (g) of this question.

10.Calculate the cost of equity and the weighted average cost of capital the company will have with its new capital structure when there is a 25% corporate tax rate in the country. 11.Briefly explain the change in the cost of equity and weighted average cost of capital as the firm goes from being an all equity financed firm to 30% debt-70% equity financed firm.

Answer 1