Volunteer Fabricators, Inc. (VF) currently has zero debt. It is a zero growth co

Question

Volunteer Fabricators, Inc. (VF) currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below.

EBIT = $80,000 New Debt/Value = 20%
Growth = 0% New Equity/Value = 80%
Orig cost of equity, rs = 10.0% No. of shares = 10,000
New cost of equity = rs =11.0% Price per share = $48.00
Tax rate = 40% Interest rate = rd = 7.0%

Part 1
If this plan were carried out, what would be VF's new WACC and its new value of operations?

Part 2

Now assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations. Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?

Debt/Value = 40% Value of new debt = $213,333
Equity/Value= 60% New WACC = 9.0%

Part 3
Based on the data in the previous two problems, what would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?

Show the calculations

Explanation / Answer

Part 1:

Calculate the VF's new WACC and its new value of operations:

Details

Amount

Value of operations = EBIT (1-T)/WACC

$ 533,333

Add: Value of T bills

$             -  

Total value

$ 533,333

Less: Repurchase

$ 213,333

Value of equity

$ 320,000

New shares = old –debt / Price = 6,000

Stock price is as follows:

= Value of equity / Number of shares

= $320,000 /6,000

= $53.33

Details

Amount

Value of operations = EBIT (1-T)/WACC

$ 533,333

Add: Value of T bills

$             -  

Total value

$ 533,333

Less: Repurchase

$ 213,333

Value of equity

$ 320,000

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