Question
Question 1. You are a corporate finance analyst at a management consulting firm, which has been approached by a company for advice on its capital
Question 1.
You are a corporate finance analyst at a management consulting firm, which has been approached by a company for advice on its capital structure decisions. The company, Boston Turkey Inc., has been in existence for only two years, and its stock is currently trading at $20 per share (There are 100,000 shares outstanding.) The following are the most recent financial statements of the company:
Income Statement
| Revenues | $1,000,000 | ||
| Expenses | $400,000 | ||
| Depreciation | $100,000 | ||
| EBIT | $500,000 | ||
| Interest Expense | $100,000 | ||
| Taxable Income | $400,000 | ||
| Tax | $160,000 | ||
| Net Income | $240,000 | ||
| Balance Sheet | |||
| Current Assets | $1,000,000 | Accounts payable | $500,000 |
| Land & Buildings | $500,000 | Long Term Debt | $1,000,000 |
| Property, Plant & Equipment | 1,500,000 | Equity (100,000 shares) | $1,500,000 |
| Total Assets | $3,000,000 | Total Liabs. & Equity | $3,000,000 |
Due to its limited history, the beta of the stock cannot be estimated from past prices. You do have information about comparable listed firms and their betas
| Firm | Beta | Debt/Equity Ratio |
| Arizonas Baked Chicken | 1.05 | 20% |
| Barbees Chicken | 1.20 | 50% |
| Eyepops Chicken | 0.90 | 10% |
| Bob Roy Chicken & Fish | 1.35 | 70% |
(The comparable firms all have the same tax rate as Boston Turkey). You can assume that the market risk premium is 5.5%.
As general information, you have also collected data on interest coverage ratios, ratings and interest rate spreads, and they are summarized below:
| Rating | Coverage Ratio greater than | and Coverage Ratio less than | Spread over T-bond |
| AAA | 9.65 |
| 0.30% |
| AA | 6.85 | 9.35 | 0.70% |
| A+ | 5.65 | 6.85 | 1.00% |
| A | 4.49 | 5.65 | 1.25% |
| A- | 3.29 | 4.49 | 1.50% |
| BBB | 2.76 | 3.29 | 2.00% |
| BB | 2.17 | 2.76 | 2.50% |
| B+ | 1.87 | 2.17 | 3.00% |
| B | 1.57 | 1.87 | 4.00% |
| B- | 1.27 | 1.57 | 5.00% |
| CCC | 0.87 | 1.27 | 6.00% |
| CC | 0.67 | 0.87 | 7.50% |
| C | 0.25 | 0.67 | 9.00% |
| D | -100000 | 0.25 | 12.00% |
The treasury bill rate is 3.00% and the treasury bond rate is 6.25%.
a. What is the current cost of equity?
b. What is your best estimate of the current after-tax cost of debt? (The company is not rated
currently). Justify your answer.
c. What is the current cost of capital?
d. As part of your analysis, you are examining whether Boston Turkey should borrow
$500,000 and buy back stock. If it does so, its rating will drop to A-. If it does so,
what will the new cost of equity be?
e. How much will the stock price change if it borrows $500,000 and buys back stock?
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Managing Finance
Authors: CMI Books
1st Edition
1781252181, 978-1781252185
