Question

The debt has an interest rate of 8.50% (short term) and 10.50% (long term). The expected rate of return on the company's shares is 17.50%. There are 7.66 million shares outstanding, and the shares are trading at €36. The tax rate is 25%. Assume the company issues €50 million in new equity and uses the proceeds to retire long-term debt. Also assume the company's borrowing rates are unchanged and the short-term debt is permanent. Use the three-step procedure.a. Calculate the cost of equity after the capital restructuring

Answer 1

Re = 16.02%

Step-by-step explanation:

current stock price 36 x 7,660,000 = 275,760,000

cost of equity = 17.5%

current short term debt = 141,600,000

cost of short term debt = 8.5%

current long term debt = 210,600,000

cost of long term debt = 10.5%

total financing = 627,960,000

• equity = 275,760,000 / 627,960,000 = 0.4391
• short term debt = 141,600,000 / 627,960,000 = 0.2255
• long term debt = 210,600,000 / 627,960,000 = 0.3354

WACC = (0.4391 x 0.175) + (0.2255 x 0.085 x 0.75) + (0.3354 x 0.105 x 0.75) = 0.0768 + 0.0144 + 0.0264 = 0.1176 or 11.76%

under the new structure:

total financing = 627,960,000

• equity = 325,760,000 / 627,960,000 = 0.5188
• short term debt = 141,600,000 / 627,960,000 = 0.2255
• long term debt = 160,600,000 / 627,960,000 = 0.2557

assuming WACC remains unchanged:

0.1176 = (0.5188 x Re) + (0.2255 x 0.085 x 0.75) + (0.2557 x 0.105 x 0.75) = (0.5188 x Re) + 0.0144 + 0.0201 = (0.5188 x Re) + 0.0345

0.5188 x Re = 0.1176 - 0.0345 = 0.0831

Re = 0.0831 / 0.5188 = 0.1602 or 16.02%