Reed\'s Cycles is considering a capital restructuring to allow $350 Million in d

Question

Reed's Cycles is considering a capital restructuring to allow $350 Million in debt. Currently,
RC is an all-equity rm with earnings before interest and taxes of $420 Million. Suppose un-
levered rms in the same industry have betas of 0.80. Assume the market risk premium is
6.5% and the risk-free interest rate is 4%. Assume that the corporate tax rate is 35%. You
may assume that all earnings are paid out as dividends, and you may assume that the debt is
used to buy back stock. For simplicity, assume that cash flows are perpetual as are payments
on the debt.
How would the proposed restructuring change the value of RC as a whole?

Explanation / Answer

EBIT= 420 million

Re= 4% + 0.8*6.5%= 9.2%

Value of unlevered firm = 420*(1-35%)/9.2%=2967.391

Value of RC = 2967.391 + 350*35%=$3089.90

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