1. Funeral Parlors of America, Inc. (FPA), is a publicly-traded funeral homes company with 18 million shares of stock outstanding trading at $100 per share. They have a relatively conservative balance sheet with only $200 million market value of debt.
The expected return on the debt is 5% and the beta of the equity of FPA equity is .8. The risk free rate of interest is 4% and the expected market risk premium is 7.5%. The corporate tax rate is 20%.
Calculate the after tax WACC (at this capital structure) for FPA.
2. Continuing problem 1, assume that the answer you got for the WACC in problem 1 was 9.4%. FPA management would like to increase its leverage to 20% debt/value (its debt/value ratio in problem 1 was 10%) and will pay the proceeds of its new borrowing out via a one-time dividend payout to shareholders. They believe that this capital structure change will reduce the weighted average cost of capital. (The capital structure change will not change any of the operations or the riskiness of future operating free cash flows.)
a. Calculate FPA’s new cost of capital using the three-step procedure outlined in Section 19-3 of Brealey, Myers and Allen. Assume that the expected return on the b. debt at the new debt ratio remains at 5% (same value as in problem 1).
b. Was the management correct? Did the WACC decline as a result of this recapitalization?
c. Why did the WACC decline as a result of this recapitalization?