Alco, Inc. is a zero growth firm with expected EBIT of $600,000. The current cos

Question

Alco, Inc. is a zero growth firm with expected EBIT of $600,000. The current cost of equity for this zero debt firm is 16%. Suppose Alco announces that it will borrow $800,000 at a 10% interest rate and use the proceeds to buy up stock. The corporate tax rate is 30%. (Assume MM World with taxes.)

a) What is the expected value of the firm before it announces the restructuring?

b) What is the expected value of the firm after the restructuring?

c) What is the cost of equity after the recapitalization?

Explanation / Answer

a)Value of firm=EBIT/cost of equity

=600000/16%=$3,750,000

b)Value of levered=value of unlevered+(Tax rate*value of debt)

=3750000+(0.3*800000)

=$3,990,000

c)Re(Levered)=Re(unlevered)+D/E*(return without debt-cost of debt)*(1-tax)

=16%+(800000/(3750000-800000))*(16%-10%)*(1-0.3)

=17.14%

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