Barnes Baskets, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08.
-BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values. The debt would have an interest rate of 7%. The new funds would be used to repurchase stock.
It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise to 14%. If this plan were carried out, what would BB's new value of operations be?
A) $498,339
B) $512,188
C) $525,237
D) $540,239
E) $590,718

Question

Quizplus · Accepted Answer

The correct answer is A.The new value of operations is the present value of the future cash flows of the firm. The future cash flows are the EBIT multiplied by (1 - tax rate). The present value of the future cash flows is the future cash flows divided by the cost of capital. The cost of capital is the weighted average cost of debt and equity. The weighted average cost of debt is the interest rate multiplied by the proportion of debt in the capital structure. The weighted average cost of equity is the required rate of return on equity multiplied by the proportion of equity in the capital structure. The new value of operations is:$100,000 * (1 - 0.4) / (0.07 * 0.2 + 0.14 * 0.8) = $498,339