You have been asked to analyse the capital structure of Fairly Large Company Inc
ID: 2794091 • Letter: Y
Question
You have been asked to analyse the capital structure of Fairly Large Company Inc (FLC), and make recommendations on a future course of action. FLC has 40 million shares outstanding, selling at $20 per share and a debt-equity ratio (in market value terms) of 0.25. The beta of the stock is 1.20, and the firm currently has a A rating, with a corresponding market interest rate of 6%. The firm's income statement is as follows: EBIT $150 million Interest Exp. $ 20 million Taxable Inc. $130 million Taxes $ 52 million Net Income $ 78 million The current risk free rate is 4% and the market risk premium is 5.5%.
Questions:
a. What is the firm's current weighted average cost of capital?
b. The firm is proposing borrowing an additional $200 million in debt and repurchasing stock. If it does so its rating will decline to BB+, with a market interest rate of 8%. What will the Weighted average cost of capital (WACC) be if they make this move?
c. What will the new stock price be if they borrow $200 million and repurchase stock (assuming rational investors)? (You may assume a growth perpetuity to compute the change in firm value)
Explanation / Answer
a. Expected return on equity as per CAPM = Rf + (Rm-Rf) Beta
= 4 + (5.5) * 1.2 = 10.6%
Tax rate = 52 / 130 = 40%
Cost of debt after tax = 6 * (1-40%) = 3.6%
WACC = 0.25 ( 3.6%) + 0.75 ( 10.6%) = 8.85%
b. Current market capitalisation = 40 million * $20 = $ 800 Million
Debt in market value terms (25%) = $ 200 Miilion
New Debt = 200 + 200 = $ 400 Million
New market capitalization = 800 - 200 = $ 600 Miilion
New Debt equity ratio = 400 / 600 = 0.67
New WACC = (4/6 * 3.6%) + (2/6 * 10.6%) = 14.78%
c. Firm value = Market capitalization + Net debt
= $ 600 Million + $ 400 Million
= $ 1000 Million
Stock price = 1000 Million / 30 Million = $ 33.33
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