WACC and Company Valuation Mini Case Study Brian Jones is a 30-year-old managing director of Full Charge Corporation. Recently promoted to the role upon the retirement of his father, he is the third generation of his family to run the business. Historically Full Charge Corporation had been a significant player in the market for battery production for diesel and petrol fuelled vehicles. More recently, the business has pivoted toward addressing demand for batteries used in electric vehicles. Despite strong and steady profitability in recent years, Full Charges share price had been relatively stagnant at around $25 per share. Brian felt that this was in part due to the financial policies followed by his father, which he viewed as overly conservative. Full Charge Corporation have historically been 100% equity financed with no debt in the capital structure. Full Charge Corporation are active in the production of a technology that will help reduce environmentally harmful emissions and thus they benefit from a major tax break. More specifically, they pay zero corporation tax. Noting that unconventional monetary policies had supressed yields (and thus lowered borrowing costs) in the aftermath of the financial crisis, Brian proposed that Full Charge make a significant change to its capital structure. He proposed that the company buy back $500m of its outstanding shares using cash raised by issuing new debt. He estimated that the cost of this debt would be around 4% based on prevailing market yields on the debt of firms with similar levels of credit quality. Brian was confident that this policy would make shareholders (of which he was one) better off. In aggregate, those who sold would receive $500m in cash, but Brian projected the share price for the remaining shareholders would also rise as a result of his actions. Historically Full Charge had a policy of returning all company profits to shareholders in the form of a dividend, and Brian was clear that this policy should continue. Whilst reducing the share-count would mean that in aggregate less dividends would be distributed, he was confident that the dividend paid per share would increase. His accounting department prepared the following basic set of pro forma financial statements for the coming year (for the all equity-financed firm) Full Charge Corp Pro- Forma Financial Statement All figures (except per share) in $m Shares Outstanding Measured in Millions Income Statement Revenue 1500 Operating Expenses 1375 Operating Profit 125 Net Income 125 Dividends 125 Shares Outstanding 62.5 Dividends Per Share 2.00 Balance Sheet Current Assets 450 Fixed Assets 550 Total Assets 1000 Total Debt 0 Total Equity 1000 Total Capital 1000 Inflation was currently running at close to zero. Revenue and operating expenses were thus projected to remain at the same amount per year indefinitely. Brian observed that the companys equity beta was around 0.8 whilst the market risk premium was around 5%. He estimated the current cost of equity of the no-debt firm as 8%. On the basis of an estimated cost of debt of 4%, Brian argued that any increase in debt would lead to a lowering of the companys capital cost. He thought If we aggressively seek the best deals for raw materials, why shouldnt we extend the same philosophy to our capital? Brians colleague and MBA graduate, Amanda, expressed some concerns about the restructuring. Firstly, she asserted that the proposed action might boost EPS, however adding debt to the capital structure would magnify the sensitivity of EPS to changes in operating profit. Furthermore, she expressed doubt as to whether or not the restructuring would have the share price impact Brian predicted. Provide some financial analysis to help support Amandas line of reasoning. (For ease of exposition, assume that there are neither distress costs nor signalling value associated with capital structure decisions). Given the growth in the market for electric vehicles, the government is weighing up whether to drop the tax exemption enjoyed by Full Charge Corporation. More specifically, there is debate about the introduction of a 20% corporation tax rate for companies in this market. What would this proposed tax change mean for the post restructuring weighted average cost of capital (WACC) and the share price of Full Charge? (For the scenario where corporate taxes apply, assume that the post-restructuring share count equals 39.4m). Again, assume there are neither distress costs nor signalling implications associated with capital structure decisions. Explain the underlying mechanisms that lead to any changes in the WACC and share price.