XYZ, Inc. is currently capitalized with 100% equity that has a current cost of 8
ID: 2798476 • 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
Current capital strcuture = 100% equity Cost of equity = 8% Beta = 1.50 EBIT = $ 120 million Rate of tax = 35% Risk free retturn = 3% Cost equity = Rf + bets ( rm- rf) 8 = 3+ 1.5 (Rm-3) Rm = 6.33% Lest find out the Cost of equity at different debt struture Particulars 0% 10% 20% 30% 40% Cost of debt before tax 0 5.50% 6% 6.50% 7% Tax rate 35% 35% 35% 35% 35% After tax cost of debt 0% 3.58% 3.90% 4.23% 4.55% Beta unlevered 1.5 1.5 1.5 1.5 1.5 Beta unlevered = beta unlevered /1+ (1-taxrate)*(debt/equity) 1.5 1.5/1+ (1-0.35)*(0.10/0.90) = 1.40 1.5/1+ (1-0.35)*(0.20/0.90) = 1.31 1.5/1+ (1-0.35)*(0.30/0.90) = 1.23 1.5/1+ (1-0.35)*(0.40/0.90) = 1.16 Risk freereturn 3% 3% 3% 3% 3% Market return 6.33% 6.33% 6.33% 6.33% 6.33% Risk premium 3.33% 3.33% 3.33% 3.33% 3.33% Cost of equity 8.00% 7.66% 7.36% 7.10% 6.86% DEBT 0.00% 10% 20% 30.00% 40% EQUITY 100% 90% 80% 70% 60% WACC 7.99500% 7.25330% 6.66984% 6.23463% 5.93768% EBIT 120 120 120 120 120 VALUE OF THE FIRM 1500.938 1654.419368 1799.143608 1924.733304 2020.991364 At 40% debt and 60% equity the value of the firm is increasing. So that is the best option
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