Trident Corporation is currently worth $1,000,000. Its current debt-to-value (D/V) ratio is 40%. The company is confident in meeting its debt obligation, and wants to introduce more debt to take advantage of the tax shield of interest payment. It is planning to repurchase part of the common stock by issuing more corporate debt. As a result, the firm’s debt value is expected to rise from $400,000 to $500,000. The cost of debt is 10 percent per year. Trident expects to have an EBIT of $200,000 per year in perpetuity. Trident’s tax rate is 50%. What would be the market value of Trident Corporation if it were unlevered? What would be the expected return on equity if Trident were an all-equity firm? What is the expected return on the firm’s equity before the announcement of the stock repurchase plan? What is the value of equity after the announcement of the stock repurchase plan? How much money do the equityholders expect to receive each year under the new capital structure? What is the expected return on the firm’s equity after the announcement? How much does the value of the firm increase after the announcement? If the goal is to maximize the firm’s value, would you recommend the CEO of Trident to borrow as much as they can? Please explain your rationale. Ignore the cost of financial distress and agency cost. Now we consider the downside of debt borrowing: cost of financial distress and agency cost. The more debt there is, the more costly it could be when the firm fails to meet its debt obligation. Suppose the firm expects to incur an additional cost of $40,000 for this $100,000 increase in leverage. If the goal is to maximize the firm’s value, would you recommend the CEO of Trident to proceed with this repurchase plan? Please explain your rationale.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Trident Corporation is currently worth $1,000,000. Its current debt-to-value (D/V) ratio is 40%. The company is confident in meeting its debt obligation, and wants to introduce more debt to take advantage of the tax shield of interest payment. It is planning to repurchase part of the common stock by issuing more corporate debt. As a result, the firm’s debt value is expected to rise from $400,000 to $500,000. The cost of debt is 10 percent per year. Trident expects to have an EBIT of $200,000 per year in perpetuity. Trident’s tax rate is 50%.
- What would be the market value of Trident Corporation if it were unlevered? What would be the expected return on equity if Trident were an all-equity firm?
- What is the expected return on the firm’s equity before the announcement of the stock repurchase plan?
- What is the value of equity after the announcement of the stock repurchase plan? How much money do the equityholders expect to receive each year under the new capital structure? What is the expected return on the firm’s equity after the announcement?
- How much does the value of the firm increase after the announcement? If the goal is to maximize the firm’s value, would you recommend the CEO of Trident to borrow as much as they can? Please explain your rationale. Ignore the cost of financial distress and agency cost.
- Now we consider the downside of debt borrowing: cost of financial distress and agency cost. The more debt there is, the more costly it could be when the firm fails to meet its debt obligation. Suppose the firm expects to incur an additional cost of $40,000 for this $100,000 increase in leverage. If the goal is to maximize the firm’s value, would you recommend the CEO of Trident to proceed with this repurchase plan? Please explain your rationale.
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