Precision Manufacturing (PM) has 10 million shares of stock outstanding that trade at $120. The risk-free interest rate is 3% and the market risk premium is 7%. This stock has a beta of 2.2. PM also has $500 million in 12% bonds outstanding, and the company has a 40% tax rate. Show all calculations for each of your answers to earn full credit.
Part 1: a) Calculate the firm’s market capitalization and then calculate the enterprise value. b) Use the CAPM formula to determine the firm’s cost of equity. c) Utilize this information to calculate Precision Manufacturing’s weighted average cost of capital.
Part 2: a) Assume that PM issues $240 million in common stock to buy back $240 million in bonds in order to recapitalize the firm and lower its annual interest expenses. What is Precision Manufacturing’s new WACC? b) Finally, discuss why there is a change in WACC and explain the impact of the components of capital structure on a company’s cost of capital.