XYZ, Inc. is currently capitalized with 100% equity that has a current cost of 8
ID: 2797674 • Letter: X
Question
XYZ, Inc. is currently capitalized with 100% equity that has a current cost of 8.00% and a beta of 1.50. They are considering issuing debt to recapitalize. The firm has talked with an investment bank who estimates that they will be able to issue debt according to the following cost schedule (with no more than 40% debt). XYZ has EBIT of 120 million with a corporate tax rate of 35%. The risk-free rate is 3%. What is the firm's optimal capital structure? What is the WACC at this level, and what is the new firm value?
(Complete the analysis within the file and write a brief answer to the questions about the firm's capital structure in the text box)
Before-Tax Cost
10%
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XYZ, Inc. is currently capitalized with 100% equity that has a current cost of 8.00% and a beta of 1.50. They are considering issuing debt to recapitalize. The firm has talked with an investment bank who estimates that they will be able to issue debt according to the following cost schedule (with no more than 40% debt). XYZ has EBIT of 120 million with a corporate tax rate of 35%. The risk-free rate is 3%. What is the firm's optimal capital structure? What is the WACC at this level, and what is the new firm value?
(Complete the analysis within the file and write a brief answer to the questions about the firm's capital structure in the text box)
Explanation / Answer
Using CAPM, lets calculate Market Rate of Return
E(r) = Rf + Beta*(Rm -Rf)
E(r) - Expected Return of Equity
Rf - Risk Free Rate
Rm - Market Rate of Return
Beta of an equity
8.0 = 3.0 + 1.5*(Rm - 3.0)
Rm = (5.0/1.5) + 3.0 = 6.33%
Let's use 40% Debt and 60% Equity for determining the WACC
WACC = 40%*cost of debt*(1-tax rate) + 60%*cost of common equity
WACC = 0.4*0.07*(1 -0.35) + 0.6*0.08 = 0.0182 + 0.048 = 0.0662 = 6.62%
In order to determine value of the firm, we first need to calculate FCFF
FCFF - Free Cash Flow to the Firm
FCFF = Net Income + Non- Cash Charges (Amortization/Depreciation) + Interest*(1-Tax Rate) - Fixed Capital Expenditure - Working Capital Expenditure
Asumming,
Non- Cash Charges (Amortization/Depreciation) = 0
Fixed Capital Expenditure = 0
Working Capital Expenditure = 0
FCFF = EBIT = 120 milion
Then Value of the Firm is determined by
Firm Value = FCFF /(1 + WACC) = 120/(1+ 0.0662) = 112.55 million
Calculating Beta we need correlation between Market and Asset and SD of Asset and Market
Using the above approach we can determine the option capital structure where Firm Value is maximum.
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