United Producers (UP), an unleveraged firm, has a total market value of $10 million, consisting of 500,000 shares of common stock selling at $20 per share. Management is considering recapitalizing by issuing enough debt so that the firm has a capital structure consisting of 20 percent debt (based on market values) at a before-tax cost of 10 percent. UP will use the proceeds to repurchase stock at the new equilibrium market price. UP’s marginal tax rate is 40 percent. It has earnings before interest and taxes (EBIT) of $2 million; it expects zero growth in EBIT, and it pays out all earnings as dividends.
a. What is UP’s current cost of equity?
b. If the risk free rate is 7 percent and the market risk premium is 5 percent, what is UP’s unlevered beta?
c. What is the levered beta at the new capital structure of 20 percent debt?
d. What is the new cost of equity under the capital structure financed with 20 percent debt?
e. What is its new weighted average cost of capital?
f. What is the new total corporate value of UP?
g. What is the new stock price?
h. How many shares remain outstanding after the recapitalization?