Problem 1: The ABC Company currently has $200,000 market value and book value of perpetual debt outstanding carrying a coupon of rate of 6 percent. Its earnings before interest and taxes (EBIT) are $100,000 and it is zero growth company. ABC's current cost of equity is 10 percent and its tax rate is 40 percent. The firm has 10,000 shares of common stock outstanding.
a. What is ABC's current total market value?
b. What is ABC's current stock price?
c. The firm is considering recalling the 6 percent debt and issuing $400,000 of new debt. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7 percent, while the required rate of return on equity would increase to 11 percent. If this plan were carried out, what would be ABC's new stock price?
d. Now assume that ABC can increase debt to $400,000 without refunding the $200,000 of 6 percent. Further, assume that the required return on all debt is 7 percent and that the required return on equity would again increase to 11 percent. Under these assumptions, what would be ABC's new stock price?
e. When the original debt was not refunded, ABC repurchased fewer shares and hence there were shares remaining after the repurchase. Yet the ending stock price was higher. Where did the "extra" value come from?
Problem 2: The Hat Corporation is a zero growth firm with an expected EBIT of $250,000 and a corporate tax rate of 40 percent. Hat uses $1 million of debt financing, and the cost of equity to an unlevered firm in the same risk class is 15.0 percent. The personal tax rates of Hat's investors are 30 percent on debt (interest) income and 20 percent (on average) on income from stocks.
a. What is the value of the firm according to MM (Modigliani & Miller) with corporate taxes?
b. What is the firm's cost of equity if its debt cost is 10.0 percent?