Problem:
You are in a perfect capital market setting. As CFO of XYZ Corporation, you are asked to comment on how you can reduce the firm's weighted average cost of capital. You explain that all you have to do is issue debt and use the proceeds from the debt issue to repurchase equity. Since debt is less costly than equity the WACC will decline, causing the value of the firm to go up. The firm is worth $ 80 million, and the cost of capital is 20%. There is 50% debt in the capital structure, and the cost of debt is 3% (explain all answers fully):
Requirement:
Question 1: Find the cost of equity.
Question 2: What is the Value of the Debt, and Value of the Equity to this firm?
Question 3: If the firm issues $20 million in new equity, and uses the proceeds to repurchase debt, how will the value of the firm change as a result of this capital structure change?
Question 4: What will the new cost of equity be if the cost of debt doesn't change?
Question 5: What happens to stockholders' wealth as a result of this capital structure change (explain fully)
Note: Provide support for your underlying principle.