Petrol Steel is a highly levered company with 20 million shares, trading at £10 per share and £800 million in debt outstanding.
The pre-tax cost of debt for the company is 10%, the corporate tax rate is 40% and the levered beta for the company is 3.06. The risk-free rate is 3% and the market risk premium is 5%.
Requirements:
a. What is the firm’s current weighted average cost of capital? [10p)
b. A bondholder in the firm is willing to accept 20 million newly issued shares in the company in exchange for £200 million in debt (which will be retired). This transaction will raise the company’s bond rating to BBBand lower their pre-tax cost of debt to 7.5%. Estimate the new cost of capital if the company agrees to this deal. (20p)
c. Assume that the company agrees to the swap of equity for debt (from part b). Further assume that the firm is in perpetual growth, growing 2% a year forever, what is the company’s share price after the transaction? (30p)