Rayburn Manufacturing, Inc. and KIC, Inc.: weighted average cost of capital, cost of equity, noncallable bonds and more...
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Rayburn Manufacturing, Inc., is currently an all-equity firm that pays no taxes. The market value of the firm's equity is $2 million. The cost of this unlevered equity is 18 percent per annum. Rayburn plans to issue $400,000 in debt and use the proceeds to repurchase stock. The cost of debt is 10 percent per annum.
a. After Rayburn 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. Use your answer to (b) to compute Rayburn's weighted average cost of capital after the repurchase. Is this answer consistent with (a)?
KIC, Inc., plans to issue $5 million of perpetual bonds. The face value of each bond is $1,000. The annual coupon on the bonds is 12 percent. Market interest rates on one-year bonds are 11 percent. With equal probability, the long-term market interest rate will be either 14 percent or 7 percent next year. Assume investors are risk-neutral.
a. If the KIC bonds are noncallable, what is the price of the bonds?
b. If the bonds are callable one year from today at $1,450, will their price be greater than or less than the price you computed in (a)? Why?
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1. This problem is based on the Modigliani-Miller Propositions without Taxes:
Assumptions:
? No taxes
? No transaction costs
? Individuals and corporations borrow at same rate
Results:
Proposition I:
VL = VU (Value of levered firm equals value of unlevered firm)
The cost of capital does not change if the capital structure changes.
Proposition II:
rE = rA + D/E*(r0 - rD)
rE is the cost of equity
rD is the cost of debt
rA is the cost of capital for an all-equity firm
rWACC is a firm's weighted average cost of capital. In a world with no
taxes, rWACC for a levered firm is equal to rA.
a. After Rayburn repurchases the stock, what will the firm's weighted
average cost of capital be?
Since Rayburn manufacturing is an all-equity firm the value of the
firm's assets equals the value of its equity. The MM-Proposition I
establishes that the value of a firm will not change due to a capital
structure change, and the overall cost of capital will remain
unchanged. Therefore, the Rayburn's overall cost of capital will be
18%.
b. After the repurchase, what will the cost of equity be?
If you call:
rA = expected return on assets (cost of capital)
E = market value of equity
D = market value of debt
rD = cost of debt (= 10%)
V = value of firm ; since the initial firm's equity worth is $2
million, when the capital structure changes, V remains constant, then
we have with the new capital structure that:
$2 million = E + D ==>
==> E = $2 million - D = $2,000,000 - $400,000 = $1,600,000
MM-Proposition II states that the cost of equity rE is:
rE = rA + (rA-rD)*D/E =
= 0.18 + (0.18-0.10)*(400,000/1,600,000) =
= 0.20
The cost of equity will be 20%.
...
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