Problem:
The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current cost of equity is 8.8 percent, and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00.
A. What is AJC's current total market value and weighted average cost of capital?
The firm is considering moving to a capital structure that is comprised of 40 percent debt and 60 percent equity, based on market values. 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 9.5 percent.
B. If this plan were carried out, what would be AJC's new WACC and total value?
Now assume that AJC is considering changing from its original capital structure to a new capital structure with 50 percent debt and 50 percent equity.
C. If it makes this change, its resulting market value would be $820,000. What would be its new stock price per share?
Now assume that AJC is considering changing from its original capital structure to a new capital structure that results in a stock price of $64 per share. The resulting capital structure would have a $336,000 total market value of equity and $504,000 market value of debt.
D. How many shares would AJC repurchase in the recapitization?