Question

You have been called in as a consultant for Herbert’s a sporting goods retail firm, which is examining its debt policy. The firm currently has a balance sheet as follows:
The firm’s income statement is as follows:
Revenues .............. $250
Cost of goods sold (COGS) ...... $175
Depreciation ........... $25
EBIT .............. $50
Long-term interest .......... $10
EBT .............. $40
Taxes ............... $16
Net income ............ $24
The firm currently has 100 shares outstanding, selling at a market price of $5 per share and the bonds are selling at par. The firm’s current beta is 1.12, and the risk-free rate is 7%.
a. What is the firm’s current cost of equity?
b. What is the firm’s current cost of debt?
c. What is the firm’s current weighted average cost of capital?
d. Assume that management of Herbert’s is considering doing a debt-equity swap (i.e., borrowing enough money to buy back seventy shares of stock at $5 per share). It is believed that this swap will lower the firm’s rating to C and raise the interest rate on the company’s debt to 15%.
e. What is the firm’s new cost of equity?
f. What is the effective tax rate (for calculating the after-tax cost of debt) after the swap? What is the firm’s new cost of capital?


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  • CreatedApril 15, 2015
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