# ABC Company: total market value, current stock price, and more...

The ABC Company currently has $200,000 market value and book value of perpetual debt outstanding carrying a coupon of rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000 and it is zero growth company. ABC's current cost of equity is 10 percent and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding.

a. What is ABC's current total market value?

b. What is ABC's current stock price?

c. The firm is considering recalling the 6 percent debt and issuing $400,000 of new debt. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7 percent, while the required rate of return on equity would increase to 11 percent. If this plan were carried out, what would be ABC's new stock price?

d. Now assume that ABC can increase debt to $400,000 without refunding the $200,000 of 6 percent. Further, assume that the required return on all debt is 7 percent and that the required return on equity would again increase to 11 percent. Under these assumptions, what would be ABC's new stock price?

e. When the original debt was not refunded, ABC repurchased fewer shares and hence there were shares remaining after the repurchase. Yet the ending stock price was higher. Where did the "extra" value come from?

The Hat Corporation is a zero growth firm with an expected EBIT of $250,000 and a corporate tax rate of 40 percent. Hat uses $1 million of debt financing, and the cost of equity to an unlevered firm in the same risk class is 15.0 percent. The personal tax rates of Hat's investors are 30 percent on debt (interest) income and 20 percent (on average) on income from stocks.

a. What is the value of the firm according to MM (Modigliani & Miller) with corporate taxes?

b. What is the firm's cost of equity if its debt cost is 10.0 percent?

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The ABC Company currently has $200,000 market value and book value of perpetual debt outstanding carrying a coupon of rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000 and it is zero growth company. ABC's current cost of equity is 10 percent and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding.

a. What is ABC's current total market value?

EBIT = 100,000

Interest =200000*6%=12000

EBT =88000

Tax =40%*88000=35200

EAT=88000-35200=52800

Since it is a zero growth company, we have all EAT distributed as dividends

Total market Value of equity = EAT / Cost of equity = 52800/10%=528,000

Total Market value of ABC = Market value of equity + market value of debt

=528000+200000=728000

b. What is ABC's current stock price?

Stock price = market value of equity / number of shares

=528000/10000=$52.80

c. The firm is considering recalling the 6 percent debt and issuing $400,000 of new debt. The new funds would be used to replace the old debt and to ...

#### Solution Summary

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Valuation and Capital Budgeting for the Levered Firm

1. ABC Plc. is a manufacturer of household appliances with annual after-tax profits of £5 million. Its share price is currently trading at £6.The firm has a book value of equity of £20 million and a book value of debt of £40 million. Currently, it has 10 million shares outstanding. The company's cost of debt (before tax) is 6 percent and the beta of the company stock is 1.5. The risk-free rate is 3 percent and the expected market risk premium is 5.5 percent. The marginal tax rate is 40 percent.

(a) What is ABC Plc.'s after-tax weighted average cost of capital (WACC)?

(b) ABC is considering increasing its dividend payout to shareholders in the future and therefore plans to raise debt this year. If the company issues additional debt of £20 million, what would be the effect on the firm's WACC? Please explain your results. You can assume that the cost of debt stays the same

(c) A close competitor to ABC, Lynix Plc., currently has after-tax earnings per share of £1.20 and trades at a share price of £10.80. Which firm is valued higher by the market and what could be possible reasons for the difference in valuations? Briefly explain the valuation methodology you used and how it compares to discounted cash flow methods?

2. A quoted company has a price-to-book-value ratio of 2 and 20 million shares outstanding, each with a book value of £10. The firm's cost of equity is 12% and its cost of debt is 5%. Assume capital markets are perfect except for the fact that firms pay corporation tax of 35%.

The company balance sheet stated at book values is as follows:

Cash 20

Fixed Assets 280

Total Assets 300

Equity 200

Debt 100

Total 300

(a) What is the change in the firm's cost of equity if the firm issues new shares in order to repay half its debt? Explain why the cost of equity changes.

(b) Describe the two main theories of capital structure and how they explain observed differences in financial leverage across firms and industries.

(c) Briefly describe two ways in which a firm's investment policy can be adversely affected by financial distress

3.

(a) As a CFO of a publicly quoted company, what factors would you take into account when deciding whether to distribute surplus cash to shareholders in the form of dividends or via a share repurchase

(b) Why do venture capitalists buy convertible preferred stock?

(c) A firm is considering an issue of a perpetual bond of £60 million at 6% per annum in order to buy back equity. Corporate profits are taxed at 30%; otherwise assume capital markets are perfect. It has the following balance sheet stated at market values (£m):

Assets

Networking Capital 20

Other Assets 180

Total 200

Equity & Liabilities

Equity 200

Total 200

What would be the effect on shareholder wealth of issuing the bond?

What will the post-buyback balance sheet at market values look like?

What would be the effect on shareholder wealth if individual investors who face a personal tax rate of 20% own the equity?