Problem 2
The A.J. Croft Company (AJC) currently has $100,000 market value (and book value) of
perpetual debt outstanding carrying a coupon rate of 6%.
Its earnings before interest and
taxes (EBIT) are $150,000, and it is a zero-growth company.
AJC’s current cost of
equity is 11%, and its tax rate is 40%.
The firm has 10,000 shares of common stock
outstanding.
Please answer the following questions about AJC.
a.
What is AJC’s current total market value?
Market value = value of debt + value of common stock
100,000
+
[EBIT – I](1-T) / .11 or 785,454 = $885,454 total Mkt Val.
b.
What is AJC’s current stock price?
Current Stock Price = Value of equity / # shares = 785,454 / 10,000 = $78.55
c.
The firm is considering recalling the 6% 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%, while the required
rate of return on equity would increase to 12%.
If this plan were carried out, what
would be AJC’s new stock price?
The increase in debt will cause interest to be .07 * 400,000 = 28,000 per year.
The
amount available to the original 10,000 shares a) the new value of the equity and b)
300,000 of the new debt (the other 100,000 replaces the original debt outstanding).
New value of the equity = [150,000 – 28,000] .6 / .12 = 610,000
New price per share (the equilibrium price in the situation) = 610,000 + 300,000 / 10,000
= $91.