Spam Corp is financed entirely by common stock and has a bet

Spam Corp. is financed entirely by common stock and has a beta of 1.25. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price-earnings ratio of 7.00 and a cost of equity of 14.29%. The company’s stock is selling for $42. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with a 5.5% interest rate. The company is exempt from corporate income taxes. Assume MM are correct.

a. Calculate the cost of equity after the refinancing.

b. Calculate the overall cost of capital (WACC) after the refinancing.

c. Calculate the price-earnings ratio after the refinancing

d. Calculate the stock price after the refinancing.

e. Calculate the stock’s beta after the refinancing

Solution

P/E ratio 8 market price 42 debt rate 5.50% number of share let assume 1000 Market value of Equity 42000 Debt 42/2 21000 Old EPS =(Stock price/P-e ratio) =42/7 6 Net Income 1000*6 6000 Net Income 1000*6 6000 Less: interest 1155 Earning available to share holder 4845 Number of share 1000/2 500 new EPS 9.69 market price 42 cost of equity after the refinancing=New EPS/ market price 23.07% or alternate method = 14.29% =5.5%*.50+ke*.50 =23.08% b. The overall cost of capital (WACC). 5.5*.50+23.07*.50 14.29% c. The price-earnings ratio. 1/ke =1/23.08 4.33 d. The stock price. 42 e. The stock’s beta. (ke-kd)/(WACC-kd) (23.07%-5.5%)/(14.29%-5.5%) 2.00