Question
A particular company has no debt outstanding, operating income of $18,000,000, and a cost of equity of 12%. The price of the companys stock is
A particular company has no debt outstanding, operating income of $18,000,000, and a cost of equity of 12%. The price of the companys stock is $25 per share, the number of shares outstanding is 4,400,000, and the tax rate for the company is 21%. In an adjustment to its capital structure, the firm is considering selling bonds and simultaneously repurchasing some of its stock. If the firm moves to a capital structure with 30% debt based on market values, its cost of equity will increase to 15% to reflect the increased risk. Bonds can be sold at a cost of 7%. The company is a no-growth firm, i.e., all its earnings are paid out as dividends, and earnings are expected to be constant. A.) What is the new weighted average cost of capital if the company went from no debt to a capital structure with 30% debt? B.) For a capital structure change to 30% debt, what effect would this use of leverage have on the value of the firm? Calculate any increase or decrease in firm value. C.) What would be the price of the companys stock for a capital structure with 30% debt?
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