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Spam Corp
Spam Corp. is financed entirely by common stock and has a beta of 1.05. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price-earnings ratio of 7.20 and a cost of equity of 13.89%. The company's stock is selling for $66. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with an interest rate of 3.5%. The company is exempt from corporate income taxes. Assume MM are correct.
1) Calculate the cost of equity after the refinancing. (Enter your answer as a percent rounded to 2 decimal places.)
2) Calculate the overall cost of capital (WACC) after the refinancing. (Enter your answer as a percent rounded to 2 decimal places.)
3) Calculate the price-earnings ratio after the refinancing. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
4) Calculate the stock price after the refinancing.
5) Calculate the stock's beta after the refinancing. (Round your answer to 1 decimal place.)
Expert Solution
1) Computation of the cost of equity after refinancing:-
Cost of equity before refinancing = (Cost of equity after refinancing * Weight of equity) + (Cost of debt * Weight of debt)
13.89% = (Cost of equity after refinancing * 50%) + (3.5% * 50%)
Cost of equity after refinancing * 50% = 13.89% - 1.75%
Cost of equity after refinancing = 12.14% / 50%
= 24.28%
2) Computation of the cost of capital:-
Cost of capital = (Cost of equity * Weight of equity) + (Cost of debt * Weight of debt)
= (24.28% * 50%) + (3.5% * 50%)
= 12.14% + 1.75%
= 13.89%
3) Computation of the price earnings ratio after the refinancing:-
Price earnings ratio = 1 /Cost of equity
= 1 / 24.28%
= 4.12 times
4) Stock price after the refinancing = $66
5) Computation of the stock's beta after refinancing:-
Beta of stock = 1.05 / 50%
= 2.1
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