1) Acme Co. is assessing it current capital structure. Acme is currently financed entirely with common stock with 1,000,000 shares outstanding. Investors currently expect a 12.5% market return and the risk free rate is 5%. The beta on Acme stock is 2. Acme pays out all earnings as dividends to common shareholders. Expected earnings (EBIT) generated by the firm's assets are $3,000,000 per year and expected to continue into perpetuity. Assume agency and bankruptcy costs are zero.
a. Assuming perfect capital markets and a corporate tax rate of zero, calculate:
i. The required rate of return on equity
ii. The value of the firm
iii. The share price
b. Acme's CEO has decided to issue debt so that the firms balance sheet will be split evenly between debt and equity. He plans to issue $7,500,000 of perpetual debt with a 10% annual rate and use the proceeds to repurchase equity. Again assuming perfect capital markets and a corporate tax rate of zero, calculate
i. The value of the firm
ii. The share price
iii. The required rate of return on equity
iv. The firm's weighted average cost of capital
c. Now assume the corporate tax rate is 40%. Calculate
i. The value of the firm
ii. The share price
iii. The required rate of return on equity
iv. The firm's weighted average cost of capital