P.S. 8.4% and 9.96% are INCORRECT O\'Connell & Co. expects its EBIT to be $81,00
ID: 2383291 • Letter: P
Question
P.S.
8.4% and 9.96% are INCORRECT
O'Connell & Co. expects its EBIT to be $81,000 every year forever. The firm can borrow at 8 percent. O'Connell currently has no debt, and its cost of equity is 12 percent and the tax rate is 35 percent. The company borrows $132,000 and uses the proceeds to repurchase shares. What is the cost of equity after recapitalization? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Cost of equity What is the WACC? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) P.S. 8.4% and 9.96% are INCORRECExplanation / Answer
Answer to Part I
Prior to repurchase of Equity
EBIT = 81,000
Firm does not has any debt and hence interest outflow = 0
Tax rate = 35%
Current cost of Equity = 12%
Cost of equity is defined as the minimum rate of return a company must generate in order to convince investors in invest in shares of the company at their current market price. In effect this is the rate of return on equity which is calculated by using the formula
ROE = EAT / Equity
In the current case
EAT = EBIT - Interest - Tax = 81,000 - 0 - 81,000*.35 = 81,000 - 28,350 = 52,650
Return on Equity ROE = EAT / Equity
0.12 = 52,650 / Equity
Equity of the firm = 52,650/0.12 = 438,750
After repurchase of Equity
Amount borrowed = 132,000 which is utilised to repurchase shares
Reconstituted Equity = 438,750 - 132,000 = 306,750
EBIT = 81,000 (As the firm assums that its EBIT will be this amount forever)
Cost of Borrowed Funds = 8%
Interest cost for the year = 132,000 * 8% = 10,560
EBT= EBIT - Interest = 81,000 - 10,560 = 70,440
EAT = EBT - Tax = 70,440 - 70,440 * 0.35 = 70,440 - 24,654 = 45,786
Cost of Equity after Recapitalization ROE = 45,786 / 306,750 = 0.1493 or 14.93%
Answer to Part II
Composition of Reconstituted Capital of the firm = 306,750 (Equity) + 132,000 (debt)
Total Capital of the firm C = 438,750
Weighted Average cost of capital WACC = (E/C)* ROE + (D/C) * Cost of Debt (1-Tax rate)
WACC = (306750/438750)* 0.1493 + (132000/438750)*0.08*(1-0.35)
= 0.69915*0.1493 + 0.3085*0.08*0.75 = 0.1045 + 0.01851 = 0.12301
Therefore, WACC of the Firm = 12.30%
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.