Question 6

You have been asked by JJ Corporation, a California- based firm that manufacturers and services digital satellite TV systems, to evaluate its capital structure. They currently have 70 million shares outstanding trading at $10 per share. In addition, the company has 500,000 bonds, with a coupon rate of 8%, trading at $1000 per bond. JJ is rated BBB and the interest rate on BBB straight bonds is currently 10%. The beta for the company is 1.2, and the current risk-free rate is 6%, the market risk premium is 5%. The tax rate is 40%.

a. What is the firms current debt/equity ratio?

b. What is the firms current weighted average cost of capital?

JJ Corporation is proposing to borrow $250 million and use it for the following purposes:

Buy back $100 million worth of stock.

c. What will the firms cost of equity be after this additional borrowing?

d. What will the firms weighted average cost of capital be after this additional borrowing?

e. What will the value of the firm be after this additional borrowing? (assuming zero growth, and that the debt is perpetual)