M&M prop 2, higher value f debt higher value of company... weighted average cost of capital
Company DD gives you the following information for its operation. The dividends is $8/per share before the firm has any debts. Suppose there is a 26% corporate income tax imposed on the company. Company DD has no debt originally. There are 6 million shares of common stocks outstanding. Let the market price for the stock be $48.2 per share before debt. Suppose that there is no expansion plan for the company to either spend on working capital vs. long-term investment or to apply the accumulated retained earnings. Answer the following questions:
a) What is the cost of equity for Company DD's common stock before debt? Suppose that Company DD now has issued some bonds with 4% coupon rate recently. Let Company DD's total debts (with the above coupon bond) be $84 million and let this coupon rate represent the cost of debt, how much will be the value of stockholders' equities under Modigliani and Miller's proposition 2?
Cost of equity: $8/$48.2 = 16.59%
Value of stockholders equity:
VL = 285 million + (.25)(84 million) = 306,000,000
289,200,000+ (.26)(84million)= 311,040,000
b) What is the cost of equity for Company DD, if there's no preferred stock issued for this company?
Cost of equity will be the same i.e. 16.59 %
c) What is the weighted average cost of capital after Company DD has debts?