Cede & Co. expects its EBIT to be $63,000 every year forever. The firm can borro

Question

Cede & Co. expects its EBIT to be $63,000 every year forever. The firm can borrow at 7 percent. Cede currently has no debt, its cost of equity is 13 percent, and the tax rate is 35 percent. Assume the company borrows $169,000 and uses the proceeds to repurchase shares.

What is the cost of equity after recapitalization? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

What is the WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

Cede & Co. expects its EBIT to be $63,000 every year forever. The firm can borrow at 7 percent. Cede currently has no debt, its cost of equity is 13 percent, and the tax rate is 35 percent. Assume the company borrows $169,000 and uses the proceeds to repurchase shares.

Explanation / Answer

Value of firm when unlevered = EBIT (1 - tax rate) / cost of equity

Value (unlevered) = 63,000(1-0.35)/0.13 = $315,000

Value of the firm when levered = Value (unlevered) + Tax rate(Loan)

Value (Levered) = 315,000 + 0.35 (169,000) = $374,150

1) Cost of equity = Cost of equity + (Cost of equity - Cost of debt) x ( Loan/Value(levered) - Loan) x (1 - tax rate)

Cost of equity = 0.13+(0.13-0.07)x(169,000/374,150-169,000)x(1-0.35)

Cost of equity = 0.13 + (0.06) x (0.8238) x (0.65)

Cost of equity = 0.13 + 0.03213 = 16.21%

2) WACC = Cost of equity x (Value(Levered) - Loan) / Value(Levered) + Cost of debt x (Loan/Value(Levered)) x (1-tax rate)

WACC = 0.1621 x (374,150-169,000)/374,150 + 0.07 x (169,000/374,150) x (1-0.35)

WACC = (0.1621 x 0.5483) + (0.07 x 0.4517 x 0.65)

WACC = 0.08888 + 0.02055

WACC = 10.94%

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