Expert Q&A; Done PLEASE ANSWER IN EXCEL WITH EXPLANATION OF HOW YOU REACHED ANSW

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Expert Q&A; Done PLEASE ANSWER IN EXCEL WITH EXPLANATION OF HOW YOU REACHED ANSWER/CALCULATIONS Diablo Steel is a highly levered company with 21 million shares, trading at $10/share and $900 million in debt (in market and book value terms) outstanding. The pre-tax cost of debt for the company is 10%, the marginal tax rate is 38% and the levered beta for the company is 2.97. The risk free rate is 5% and the equity risk premium is 7%. a. Estimate the cost of capital for the company.(1 point) b. A bondholder in the firm is willing to accept 21 million newly issued shares in the company in exchange for $225 million in debt (which will be retired). This transaction will raise the company's bond rating to BBB and lower their pre-tax cost of debt to 7.5%. Estimate the new cost of capital, if you go through with the swap. (2 points) c. Assuming that you go through with the swap of equity for debt (from part b). estimate the value per share after the transaction. (You can assume that the firm is in perpetual growth, growing 1.9% a year forever) (3 points)

Explanation / Answer

Part a)

The cost of capital is calculated as below:

Cost of Capital = Weight of Debt*After-Tax Cost of Debt + Weight of Equity*Cost of Equity

Using the values provided in the question, we get,

Weight of Debt = Market Value of Debt/Total Market Value of Firm = 900/(900 + 21*10) = 900/1,110

Weight of Equity = Market Value of Equity/Total Market Value of Firm = (21*10)/(900 + 210*10) = 210/1,110

After-Tax Cost of Debt = Pre-Tax Cost of Debt*(1-Tax Rate) = 10%*(1-38%) = 6.2%

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium) = 5% + 2.97*7% = 25.79%

Substituting these values in the above formula for cost of capital, we get,

Cost of Capital = 900/1,110*6.2% + 210/1,110*25.79% = 9.91% or 10%

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Part b)

We will have to calculate the revised weights and after-tax cost of debt after the swap as below:

Weight of Debt = (Market Value of Debt after Swap)/Total Market Value after Swap = (900 - 225)/(900 - 225 + 21*10 + 21*10) = 675/1,095

Weight of Equity = (Market Value of Equity after Swap)/Total Market Value after Swap = (21*10 + 21*10)/(900 - 225 + 21*10 + 21*10) = 420/1,095

After-Tax Cost of Debt (after Swap) = Pre-tax Cost of Debt after Swap*(1-Tax Rate) = 7.5%*(1-38%) = 4.65%

Now, we can calculate the cost of capital after swap as below:

Cost of Capital after Swap = 675/1,095*4.65% + 420/1,095*25.79% = 12.76% or 13%

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Notes:

The question is not clear as to at what price the new common shares are issued. Therefore, the current share price of $10 is taken as the price for the newly issued shares.

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Part c)

The value per share after the swap is determined as below

Value Per Share after Swap = Current Share Price*(1+Growth Rate)/(Cost of Capital after Swap - Growth Rate)

Substituting values in the above formula, we get,

Value Per Share after Swap = 10*(1+1.9%)/(12.76% - 1.9%) = $93.83

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