Assume markets are perfect and MM propositions hold. CAPM holds. No taxes. Circle K Brands, Inc. total capital consists of 200,000 shares of common stock outstanding and $20 million of debt paying interest of 5%. Next year's expected operating income (pre-interest income) is $4 million per year. CKB's stock trades at a P/E of 6.67 times next year's expected earnings per share.
a. What is the price per share of CKB stock?
b. Assume that CKB's debt is diskless (I.e., that the risk free rate is also 5%). Assume that the expected market risk premium is 10%. Assume that the beta of CKB equity is 1.0. Calculate the cost of equity and the cost of capital for CKB in the current capital structure.
c. CKB is considering a new investment project. The new project will cost $5.5 million to undertake. The new project is expected to generate $500K per year in perpetuity and is expected to have the same beta risk as the rest of CKB's operations. Using your answer in part b, should CKB invest in the new project? Why or why not?
d. Assume your answer to part c was to NOT take the project. The CFO of the company is not happy, because this project was her idea and she argues that the cost of capital estimates would be reduced by using more debt to finance the project, making the investment more attractive. Explain to your CFO why her conclusion is incorrect.
e. Now ignore the project from parts C and D of the problem. Using the information at the beginning of the problem and your answers to part A and B of the problem, next consider that CKB decides to change its capital structure, holding the assets of the firm fixed. They intend to borrow an additional $10 million from the debt market. The proceeds of the new debt issue are paid out to the shareholders of the firm. The new debt has the same seniority, security and maturity as the existing debt of the firm. However, the presence of the new debt in the capital structure now introduces the possibility of bankruptcy. At the new level of debt, the cost of debt (for all the debt) is now 7%. Assume that the original debt drops in value to $15 million due to the increased risk. Assuming the MM propositions hold, what is the new cost of equity for CKB's remaining equity.