Question

Mr. Brown runs a chain of BBQ joints called A1 BBQ House (A1B). Currently A1B uses only equity capital. Mr. Brown was approached by representatives from Bankers Corp. who have pointed out to him that A1B’s cost of unlevered equity capital is 12% and the cost of debt capital is only 4%. The reps said A1B (which produces after-tax operating cash flows of $3 million per year) would benefit from using some debt since debt is the cheaper source of financing. They recommend that A1B issues $10 million worth of bonds and uses the entire proceeds to repurchase $10 million worth of its own stocks. Assume that both the firm’s cash flows and the debt are perpetual, and A1B’s corporate tax rate is 30%.

a) What is the current value of the firm without debt?

$3.0 million

$25.0 million

$75.0 million

$17.5 million

$28.0 million

$10.0 million

$37.5 million

$40.5 million

b) If Mr. Brown follows Bankers Corp.’s plan, what will be the cost of equity capital and the total value of the firm?

12.0%; and same firm value as in a)

13.1%; and same firm value as in a)

9.4%; and $25.0 million

15.1%; and $28.0 million

9.4%; and $32.0 million

17.3%; and $28.0 million

17.3%; and same firm value as in a)

9.4%; and same firm value as in a)

c) What would be the value of the firm under the Bankers Corp.’s proposal if interest expenses were not tax deductible? What would be the cost of equity capital in that case (i.e., what would be the cost of equity if Mr. Brown followed Banker Corp.’s advice even though interest expenses were not tax deductible)?

$25.0 million; 12.0%

$35.0 million; 12.0%

$25.0 million; 9.4%

$35.0 million; 9.4%

$32.0 million; 17.3%

$32.0 million; 12.0%

$25.0 million; 17.3%

$10.0 million; 4.0%

Answer 1