The Lex I. Cographer Dictionary Company has net operating income of $10 million and $20 million of debt with a 7 percent interest rate. The earnings of the company are not expected to grow, and all earnings are paid out to shareholders in the form of dividends. In all cases, assume no taxes.
a. Using the net operating income approach with an equity capitalization rate of 12.5 percent at the $20 million debt level, compute the total value of the firm and the implied overall capitalization rate, ka.
b. Next, assume that the firm issues an additional $10 million in debt and uses the proceeds to retire common stock. Also, assume that the interest rate and overall capitalization rate remain the same as in Part (a). Compute the new total value of the firm and the new implied equity capitalization rate.