ABC Company, an unleveraged firm, has a total market value of $10 million, consisting of 500,000 shares

Question:

ABC Company, an unleveraged firm, has a total market value of $10 million, consisting of 500,000 shares of common stock selling at $20/share. Management is considering recapitalizing by issuing enough debt so that the firm as a capital structure consisting of 20% debt at a before tax cost of 10%. ABC will use the proceeds to repurchase the stock at the new equilibrium market price. ABC’s marginal tax rate is 40%. It has EBIT of $2 million, it expects zero growth in EBIT and pays out all earnings as dividends.

a) Assume ABC’s levered beta is 1.15, the risk free rate (Rf) is 7% and the expected market return (Rm) is 12%. What is the new cost of equity under the capital structure financed with 20% debt?

b) Using the new cost of equity, what is the new WACC?

c) What is the new total corporate value of ABC?

Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on... Capital Structure
Capital structure refers to a company’s outstanding debt and equity. The capital structure is the particular combination of debt and equity used by a finance its overall operations and growth. Capital structure maximizes the market value of a... Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the...