A new company, KarTeX Inc, was recently founded to manufacture a new efficient fuel injection system. KarTeX is financed by $30M in perpetual debt with a 6% interest rate and 1,000,000 shares of equity with a current market price of $70. The beta of KarTeX’s stock is estimated at 1.2, the market’s risk premium is expected to be 5%, and the risk free rate is 6%. Assume the corporate income tax is 40% and personal taxes on debt and equity are 50% and 25% respectively.
What is KarTex’s tax gain from using debt in its capital structure?
What is the KarTeX’s WACC?
Assume that the unlevered cash flows are expected to be constant each year in perpetuity. What level of unlevered cash flows is required for the firm to meet its WACC?
What is KarTeX’s unlevered cost of capital, rUA?
Due to an unexpected innovation in fuel delivery systems developed by a competitor, KarTeX’s earnings are expected to decrease to $5M per year in perpetuity. Assume that the systematic risk of the firm’s assets (and hence rUA) and the value of the debt have remained unchanged. What is the new market value of equity?
What is the new required return on equity?
What is the new WACC for KarTeX?
Since WACC can be thought of as an average hurdle rate for KarTeX’s projects does your finding in part g make economic sense in light of what happened in part e? This result depends heavily on the assumption that the systematic risk of the firm’s assets (and hence rUA) and the value of the debt have remained unchanged. Why might these be unreasonable assumptions?