Question

For this and the next question: Truck Parts Company (TPC) has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10% perpetual bonds now selling at par. The company's EBIT is $13.40 million, and its tax rate is 15%. TPC can change its capital structure by either increasing its debt to $70 million or decreasing it to $30 million. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12% coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 8% coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change. Assume zero growth. What will be the value of the firm if the firm decreases its use of leverage? Assume that cost of equity will decrease to 13%.

A. $71.92 Million

B. $87.6154 Million

C. $100.9231 Million

D. $102.2442 Million

E. None of the above

QUESTION 2: What will be the value of the firm if it increases its use of leverage? Assume that cost of equity will increase to 16%.

A, $4.25 million

B. $95.3936 million

C. $96.5625 million

D. $102.6023 million

E. None of the above

Answer 1

WACC if company decrease its leverage to 30% is calculated below:

WACC = (70% × 13%) + (30% × 8%) × (1 - 15%)

= 9.10% + 2.04%

= 11.14%

WACC of company is 11.14%.

Value of firm = EBIT × (1 - tax rate) / WACC

= $11.40 × (1 - 15%) / 11.14%

= $9.69 / 11.14%

= $102.2442 million.

Value of firm is $102.2442 million.

Option (C) is correct answer.

2.

WACC if company increase its leverage to 70% is calculated below:

WACC = (30% × 16%) + (70% × 12%) × (1 - 15%)

= 4.80% + 7.14%

= 11.94%

WACC of company is 11.94%.

Value of firm = EBIT × (1 - tax rate) / WACC

= $11.40 × (1 - 15%) / 11.94%

= $9.69 / 11.94%

= $95.3936 million.

Value of firm is $95.3936 million.

Option (B) is correct answer.