Problem:
The following information is available about the capital structure of Cheng & Davis Development (CDD).
|
Capital Structure
|
Current
|
Target
|
|
|
Book Value
|
Market Value
|
Book Value
|
Market Value
|
|
Debt
|
1000
|
1000
|
-
|
40%
|
|
Equity
|
1000
|
3000
|
-
|
60%
|
(a) What transaction(s) in the capital market would CDD have to conduct to achieve its capital structure, without raising any net new capital?
(b) The equity beta of CDD's stock, estimated from recent data, is 0.8. What is the asset beta? Assume for this part that the beta of debt is approximately zero.
(c) If CDD were to change its capital structure towards its target proportions, how would this affect the equity beta of the company? Assume for this part that the beta of debt is approximately zero.
Consider the following information about market interest rates and taxes:
|
1-year risk free rate
|
2%
|
|
30-year risk free rate
|
4.5%
|
|
Market risk premium
|
6.5%
|
|
Corporate tax rate (including state taxes)
|
40%
|
|
Yield on long-term CDD bonds
|
6%
|
(d) Calculate the weighted average cost of capital (WACC) that you would use to value CDD as a stand-alone company. Assume henceforth that CDD has achieved its target capital structure, without raising any net new capital.
(e) Would you also use the cost of capital calculated under (d) to evaluate whether the management team of Karolyn Cheng and Kimberly Davis delivered value over the next year? If not, what change do you recommend? Explain your calculations.
(f) Based on your answer under (e): if next year's EBIT is 400, what is the economic income delivered by Karolyn and Kimberly?
Summary of problem:
This question belongs to Finance as well as it explains about computing cost of capital, weighted average cost of capital as well as restructuring capital without issuing any new equity capital.