1.Hartford Mining has 50 million shares that are currently trading for $4 per share and $200 million worth of debt. The debt is risk free and has an interest rate of 5%, and the expected return of Hartford stock is 11%. Suppose a mining strike causes the price of Hartford stock to fall 25% to $3 per share. The value of the risk-free debt is unchanged. Assuming there are no taxes and the risk (unlevered beta) of Hartford’s assets is unchanged, what happens to Hartford’s equity cost of capital?
2.Mercer Corp. is an all equity firm with 10 million shares outstanding and $100 million worth of debt outstanding. Its current share price is $75. Mercer’s equity cost of capital is 8.5%. Mercer has just announced that it will issue $350 million worth of debt. It will use the proceeds from this debt to pay off its existing debt, and use the remaining $250 million to pay an immediate dividend. Assume perfect capital markets.
a. Estimate Mercer’s share price just after the recapitalization is announced, but before the transaction occurs.
b. Estimate Mercer’s share price at the conclusion of the transaction. (Hint: use the market value balance sheet.)
c. Suppose Mercer’s existing debt was risk-free with a 4.25% expected return, and its new debt is risky with a 5% expected return. Estimate Mercer’s equity cost of capital after the transaction.