Copper company CCT has three million common shares outstanding, and perpetual de

Question

Copper company CCT has three million common shares outstanding, and perpetual

debt with a market value of $30 million. Its interest rate is 8%, and its corporate tax rate is 40%. Its

levered beta is 1.2. The risk-free rate is 3% and the market portfolio return is 12%.

CCT's EBIT is expected to be $10 million every year, and CCT pays out all earnings as dividends to

shareholders. CCT’s competitors have an average market-value-based debt-to-asset ratio of 20%. The

CFO would like to decrease CCT’s debt-to-asset ratio to the industry norm to decrease risk. This

would mean issuing additional equity and paying off some debt.

a) Calculate the current cost of equity, value of equity, price per share, total value of CCT and CCT’s

debt-to-asset ratio.

b) Calculate the total value of equity that CCT should issue to decrease the debt-to-asset ratio to the

industry standard. Calculate the share price following the issue of additional equity. Explain why the

share prices changes the way it does.

Explanation / Answer

a)

i. Cost of Equity = Rf + (Rm - Rf) x Beta = 3 + (12 - 3) x 1.2 = 13.8%

ii. Interest = 30,000,000 x 8% = $2,400,000
Earnings after tax = (10,000,000 - 2,400,000) x (1 - 0.40) = $4,560,000
Value of Equity = 4,560,000 / 13.8% = $33,043,478.26

iii. Price per share = 33,043,478.26 / 3,000,000 = $11.01

iv. Total value of CCT = 33,043,478.26 + 30,000,000 = $63,043,478.26
Debt to assets ratio = 30,000,000 / 63,043,478.26 = 0.48:1 or 48%

b)

i. Total Equity for 20% Debt to Assets ratio = 30,000,000 x (100 - 20)/20 = $120,000,000
Value of equity to be issued = 120,000,000 - 33,043,478.26 = $86,956,521.74

ii. The theoretical price depends upon the price at which the new shares issued. Nothing is given, thus, we will assume that new issue is made at $11.01 i.e. the current market price only. In that case the theoretical price will remain same. However, the price should rice since the company's financial risk is getting reduce due to the lower debt component in capital structure.

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