Buckeye Corp. is currently an all-equity firm with a market value of equity of $

Question

Buckeye Corp. is currently an all-equity firm with a market value of equity of $100 million. The current expected return on Buckeye's equity is 20%. Buckeye is planning on issuing $50 million in debt with an interest rate of 8% and using the cash to repurchase $50 million in shares.

Suppose that Buckeye operates in a perfect world with no taxes and no other market imperfections

(a) After Buckeye repurchases the stock, what will be the expected return on the firm's stock?

(b) After Buckeye repurchases the stock, what will be the firm's weighted average cost of capital?

Now suppose that Buckeye operates in a world with taxes but no other market imperfections and that Buckeye is in the 20-percent tax bracket.

(c) After Buckeye repurchases the stock, what will be the expected return on the firm's stock?

(d) After Buckeye repurchases the stock, what will be the firm's weighted average cost of capital?

Explanation / Answer

Answer:

Current expected return on Buckeye's equity = 20% = 20% of $ 100,000,000 = $ 20,000,000 = Earnings available for common stock holders

(a) After Buckeye repurchases the stock then; earnings available for common stock holders shall be;

$ 20,000,000 Less: Interest on debt $ 4,000,000 (8% of $ 50,000,000) = $ 16,000,000

hence, expected return on firms stock = $ 16,000,000 / $ 50,000,000 = 32%

(b) Weighted Average Cost of Capital (WACC) = Proportion of Equity x Cost of Equity + Proportion of Debt x Cost of Debt

here,

WACC = ($ 50,000,000 / $ 100,000,000) x 32% + ($ 50,000,000 / $ 100,000,000) x 8% = 20% (without tax)

(c) After Buckeye repurchases the stock then; earnings available for common stock holders shall be;

$ 20,000,000 Less: Interest on debt $ 3,200,000 {8% (1 - 0.20) of $ 50,000,000} = $ 16,800,000

hence, expected return on firms stock = $ 16,800,000 / $ 50,000,000 = 33.60%

(d) WACC = ($ 50,000,000 / $ 100,000,000) x 33.60% + ($ 50,000,000 / $ 100,000,000) x 8% (1-0.20) = 20% (with tax)

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