Problem
Vital Factory, Inc. (VF) currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the market value capital structure indicated below. The money raised would be used to repurchase stock.
It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to raise somewhat, as indicated below.
|
EBIT
|
$80,000
|
|
New Debt/Value
|
20%
|
|
Growth
|
0%
|
|
New Equity/Value
|
80%
|
|
Original cost of equity
|
10.0%
|
|
Number of shares
|
10,000
|
|
New cost of equity
|
11.0%
|
|
Price per share
|
$48.00
|
|
Tax rate
|
40%
|
|
Interest rate
|
7.0%
|
Question 1
If this plan were carried out, what would be VF's new WACC and its new value of operations?
Question 2
Now, assume that VF is considering changing from its original zero debt capital structure to a new capital structure with even more debt. This recapitalization results in changes in the cost of debt and equity, and thus to a new WACC and a new value of operations.
Assume VF raises the amount of new debt indicated below and uses the funds to purchase and hold T-bills until it makes the stock repurchase. What is the stock price per share immediately after issuing the debt but prior to the repurchase?
|
Debt/Value
|
40%
|
|
Value of new debt
|
$213,333
|
|
Equity/Value
|
60%
|
|
New WACC
|
9.0%
|
Question 3
Based on the data in the previous two questions, what would the stock price be if VF issued the new debt and immediately used the proceeds to repurchase stock?