Protron Inc. is currently an all-equity firm that currently has $200 million in assets. On average, the return on its physical assets (ROA) every year is 17.5 percent. That is, on average, EBIT is 17.5 percent of the value of the assets. However, there are fluctuations in the annual return such that the beta of the ROA is 1.25. The marginal corporate tax rate for SleazeCo is .10 (i.e., 10%). The personal tax rate of dividend and capital gains distributions is equal to that for interest income; both types of tax rates are 28 percent. The management of Protron Inc. is thinking about doing a leverage re-capitalization whereby it raises $50 million in debt at an interest rate of 2 percent and pays a one-time dividend of $50 million to the equity holders. If it does this, the fluctuations in the ROA are such that Protron Inc. can always afford to make its debt payments. Thus, the interest rate on the debt is the risk-free rate. The risk-free rate is .02 and the expected return on the market is .13.
1. What is the expected return on the equity of the re-capitalized firm?
2. What is the weighted average cost of capital after re-capitalization?
3. Why did the weighted average cost of capital change in the direction it changed?