ABC Company, an unleveraged firm, has a total market value of $10 million, consisting of 500,000 shares of common stock selling at $20/share. Management is considering recapitalizing by issuing enough debt so that the firm as a capital structure consisting of 20% debt at a before tax cost of 10%. ABC will use the proceeds to repurchase the stock at the new equilibrium market price. ABC’s marginal tax rate is 40%. It has EBIT of $2 million, it expects zero growth in EBIT and pays out all earnings as dividends.
a) Assume ABC’s levered beta is 1.15, the risk free rate (Rf) is 7% and the expected market return (Rm) is 12%. What is the new cost of equity under the capital structure financed with 20% debt?
b) Using the new cost of equity, what is the new WACC?
c) What is the new total corporate value of ABC?