O’Connell & Co. expects its EBIT to be $95,000 every year forever. The firm can

Question

O’Connell & Co. expects its EBIT to be $95,000 every year forever. The firm can borrow at 8 percent. O’Connell currently has no debt, and its cost of equity is 13 percent and the tax rate is 35 percent. The company borrows $133,000 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))

  

  

What is the WACC? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

O’Connell & Co. expects its EBIT to be $95,000 every year forever. The firm can borrow at 8 percent. O’Connell currently has no debt, and its cost of equity is 13 percent and the tax rate is 35 percent. The company borrows $133,000 and uses the proceeds to repurchase shares.

Explanation / Answer

value of equity today when there is no debt = EBIT(1-Tax)/Cost of equity

                                                                = 95000(1-.35)/.13

                                                               = 61750/.13

                                                                = $ 475,000

now if company makes repurchase by borrowing debt , cost of equity

Value of equity = 475000-133000 = 342,000

EAT= EBIT -Interest = EBT- Tax

       =95000 -(133000*8%) = 84360 -29526= 54834

Cost of equity = 54834/342000 = 16.03%

b)WACC=

approx 13%

**Weights=

equity =342000/[342000+133000]=.72

debt = 133000/[342000+1333000] =.28

Cost weights weighted cost after tax Debt 5.20            [8(1-.35)] .28 1.456 Equity 16.03 .72 11.542            WACC 12.998

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