Snowstorm Inc. expects its EBIT to be $300,000 every year forever. The firm can borrow at 10%. The firm currently has no debt, and its cost of equity is 12%. The tax rate is 40%. The firm is thinking of borrowing $340,000 and using the proceeds to buy back shares.
a) Pretend the debt/equity ratio is 0.30. What would be the cost of equity for this firm after the recapitalization?
Answer is 12% - need in-depth solution.
Value of Unlevered firm = EBIT*(1-Tax rate) / Current cost of equity
= 300000*.6 / .12
= 180000/ .12
= $1500000
Value of Levered firm = Value of Unlevered firm + Tax rate*Debt
= 1500000+ .40*340000
= 1500000+ 136000
= $1636000
Cost of equity after recapitalization = Current cost of equity + (Current cost of equity -Cost of Debt)*(Debt/(Value of Levered firm-Debt)*(1-Tax rate)
= .12 + (.012 - .10)* (340000/(1636000-340000) * .60
= .12 + 0.00314814814
= 0.12314814814
= 12.31%
Snowstorm Inc. expects its EBIT to be $300,000 every year forever. The firm can borrow at...