Hi!!
a. After the company repurchases the stock, what will the firm's
weighted average cost of capital be?
The company is an all-equity firm, then the value of the firm?s assets
equals the value of its equity. According to the MM-Proposition 1
(Modigliani-Miller) the value of a firm will not change due to a
capital structure change, and the overall cost of capital will remain
unchanged.
In a world with no taxes, for an all-equity firm, the WACC is equal to
the cost of capital.
Therefore, the company?s WACC will be 18%.
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b. After the repurchase, what will the cost of equity be? Explain?
If we call:
rA = cost of capital
E = equity
D = debt
rD = cost of debt = 10%
V = value of firm = firm's equity worth = $2 million = E + D ==>
==> E = V - D = $2,000,000 - $400,000 = $1,600,000
MM-Proposition 2 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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c. Use the answer to (b) to compute the company's weighted average
cost of capital after the repurchase. Is this answer consistent with
(a)?
WACC = D/V * rD + E/V * rE =
= 1/5 * 0.10 + 4/5 * 0.20 =
= 0.02 + 0.16 =
= 0.18
The WACC is 18%, the same answer found in a).
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I hope that this helps you. Feel free to request for a clarification
if you need it.
Regards,
livioflores-ga |
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