help in homework

New User?

Fill This Form To Receive Instant Help

Help in Homework
trustpilot ratings
google ratings


Homework answers / question archive /  United Producers (UP), an unleveraged firm, has a total market value of $15 million, consisting of 600,000 shares of common stock selling at $25 per share

 United Producers (UP), an unleveraged firm, has a total market value of $15 million, consisting of 600,000 shares of common stock selling at $25 per share

Finance

 United Producers (UP), an unleveraged firm, has a total market value of $15 million, consisting of 600,000 shares of common stock selling at $25 per share. Management is considering recapitalizing by issuing enough debt so that the firm has a capital structure consisting of 20 percent debt (based on market values) at a before-tax cost of 8 percent. UP will use the proceeds to repurchase stock at the new equilibrium market price. UP's marginal tax rate is 40 percent. It has earnings before interest and taxes (EBIT) of $2.5 million; it expects zero growth in EBIT, and it pays out all earnings as dividends.

  1. What is UP's current cost of equity?
  2. If the risk free rate is 2 percent and the market risk premium is 8 percent, what is UP's unlevered beta?
  3. What is the levered beta at the new capital structure of 20 percent debt?
  4. What is the new cost of equity under the capital structure financed with 20 percent debt?
  5. What is its new weighted average cost of capital?
  6. What is the new total corporate value of UP?
  7. What is the new stock price?
  8. How many shares remain outstanding after the recapitalization?

pur-new-sol

Purchase A New Answer

Custom new solution created by our subject matter experts

GET A QUOTE

Answer Preview

1). Computation of the current cost of equity:-

Earnings per share = EBIT * (1 - Tax rate) / Number of shares outstanding.

=$2,500,000 * (1 - 40%) / 600,000

= $1,500,000 / 600,000

= $2.50 per share

Current cost of equity = (Earnings per share / Market price per share)

= $2.50 / $20

= 12.50%

 

2). Computation of the unlevered beta:-

Cost of equity = Risk free rate + (Unlevered beta*Market risk premium)

12.50% = 2% + (Unlevered beta * 8%)

Unlevered beta * 8% = 12.50% - 2%

Unlevered beta = 10.50% / 8%

= 1.28

 

3). Computation of the levered beta:-

Levered beta = Unlevered beta*(1+(1-Tax rate)*(Debt/Equity))

= 1.28*(1+(1-40%)*(20%/80%))

= 1.28*1.15

= 1.47

 

4). Computation of the new cost of equity:-

New cost of equity = Risk free rate + (Levered beta*Market risk premium)

= 2% + (1.47 * 8%)

= 2% + 11.73%

= 13.73%

 

5). Computation of the new weighted average cost of capital (WACC):-

New WACC = (Weight of debt * After tax cost of debt) + (Weight of equity * New cost of equity)

= (20% * 8% * (1 - 40%)) + (80% * 13.73%)

= 0.96% + 10.98%

= 11.94%

 

6). Computation of the new corporate value:-

New corporate value = EBIT*(1-Tax rate) / New WACC

= $2,500,000*(1-40%) / 11.94%

= $1,500,000 / 11.94%

= $12,558,606.83

 

7). Computation of the new stock price:-

New stock price = Value of the firm / Number of shares outstanding

= $12,558,606.83 / 600,000

= $20.93 per share

 

8). Computation of the number of shares remain outstanding after the recapitalization:-

Value of debt = $12,558,606.83 * 20%

= $2,511,721.37

Number of shares repurchased = Value of debt / Price per share

= $2,511,721.37 / $20.93

= 120,000 shares

Remaining shares = 600,000 - 120,000

= 480,000 shares

Sitejabber (5.0)

BBC (5.0)

Trustpilot (4.9)

Google (5.0)