You have been asked by JJ Corporation, a California based firm that manufacturers and services digital satellite TV systems, to evaluate its capital structure. They currently have 70 million shares outstanding trading at $10 per share. In addition, the company has 500,000 convertible bonds, with a coupon rate of 8%, trading at $1000 per bond. JJ is rated BBB and the interest rate on BBB straight bonds is currently 10%. The beta for the company is 1.2, and the current risk-free rate is 6%. The tax rate is 40%.
a. What is the firm’s current debt/equity ratio?
b. What is the firm’s current weighted average cost of capital?
JJ Corporation is proposing to borrow $250 million and use it for the following purposes:
• Buy back $100 million worth of stock.
• Pay $100 million in dividends.
• Invest $50 million in a project with a NPV of $25 million.
The effect of this additional borrowing will be a drop in the bond rating to B, which currently carries an interest rate of 11%.
c. What will the firm’s cost of equity be after this additional borrowing?
d. What will the firm’s weighted average cost of capital be after this additional borrowing?
e. What will the value of the firm be after this additional borrowing? (with zero growth? with 2% growth in perpetuity)

  • CreatedApril 15, 2015
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