You have been asked to evaluate the capital structure decisions

jagguarpaw January 10, 2017 0 Comments

Question: (Capital structure) you have been asked to evaluate…

(Capital structure) You have been asked to evaluate the capital structure decisions made by the company XYZ. You have the following information about the company. The firm has 10 million shares, currently trading at $8 per share. The company is unlevered, e.g. it doesn’t use any external financing. The risk free rate is (Rf) is currently 4%, the market risk premium is estimated to be 6%. The beta of the stock equal to 0.80. The marginal tax rate is 40%.

Find the company’s cost of capital (WACC)

Now, the company is planning to change its capital structure in favour of higher leverage. The company is going to buy back 4 million shares at current market price. The stock buyback is financed by the new debt issue. The company’s debt rating is going to be Baa1 and the corres–ponding default spread over the risk free rate is going to be 1.60%. As the leverage increases, the leveraged beta of the company will be 1.04.

Find the new cost of equity, cost of debt and the company’s cost of capital (e.g. WACC)

Should the company change its capital structure and why?