Problem 1
Lowell Inc. has no debt and its financial position is given by the following data:
Assets (book = market)= $3,000,000
EBIT= $500,000
Cost of equity (Ks)= 10%
Stock price (P0)= $15
Shares outstanding n0= 200,000
Tax rate T= 40%
The firm is considering selling bonds and simultaneously repurchasing some of its stock. It if moves to capital structure with 30 percent debt based on market values, its cost of equity, Ks, will increase to 11 percent to reflect the increased risk. Bonds can be sold at a cost (Kd) of 7 percent. Lowell Inc. is a no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are exceptionally constant over time.
a. What would be the new WACC?
b.What effect would this use of leverage have on the value of the firm (Va)?
c. What would be Lowell Inc.'s stock price?
d. What happens to the firm's earnings per share after the recapitalization?