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Stock Repurchase

Poulsbo Manufacturing, ZInc. is currently an all-equity firm that pays no taxes. The market value of the firm's equity is $4 million. The cost of this unlevered equity is 15 percent per annum. Poulsbo plans to issue $700,500 in debt and use the proceeds to repurchase stock. The cost of debt is 4 percent semi-annually.

A. After Poulsbo repurchases the stock, what will the firm's weighted average cost of capital be?

B. After the repurchase, what will the cost of equity be? Explain.

C. Using the Modigliani-Miller Proposition 2, what will be the weighted average of cost of capital after the repurchase.

Again, please show all explanations and calculations in your answer.

Thanks.

Solution Preview

A. After Poulsbo repurchases the stock, what will the firm's weighted average cost of capital be?

According to Modigliani-Miller the weighted average cost of capital (rwacc) for a levered firm is equal to the cost of equity for an unlevered firm in a world with no taxes. Since Rayburn pays no taxes, its weighted average cost of capital after the repurchase will equal the cost of the firm's equity before the repurchase.

Therefore, Poulsbo's weighted average cost of capital will be 15% after the repurchase.

B. After the repurchase, what will the cost of equity be? Explain. ...

Solution Summary

The solution explains the impact on the WACC and the cost of equity of a stock repurchase.

$2.19