Expert QA Done PLEASE ANSWER IN EXCEL WITH EXPLANATION OF HO

Expert Q&A; Done PLEASE ANSWER IN EXCEL WITH EXPLANATION OF HOW YOU REACHED ANSWER/CALCULATIONS Diablo Steel is a highly levered company with 21 million shares, trading at $10/share and $900 million in debt (in market and book value terms) outstanding. The pre-tax cost of debt for the company is 10%, the marginal tax rate is 38% and the levered beta for the company is 2.97. The risk free rate is 5% and the equity risk premium is 7%. a. Estimate the cost of capital for the company.(1 point) b. A bondholder in the firm is willing to accept 21 million newly issued shares in the company in exchange for $225 million in debt (which will be retired). This transaction will raise the company\'s bond rating to BBB and lower their pre-tax cost of debt to 7.5%. Estimate the new cost of capital, if you go through with the swap. (2 points) c. Assuming that you go through with the swap of equity for debt (from part b). estimate the value per share after the transaction. (You can assume that the firm is in perpetual growth, growing 1.9% a year forever) (3 points)

Solution

a) WACC = Portion of debt*Cost of debt*(1-Tax rate) + Portion of preferred stock*Cost of preferred stock + Portion of equity*Cost of equity

Post tax cost of debt = Cost of debt*(1-Tax rate) = 10% * (1-0.38) = 6.2%

Cost of equity = risk free rate + Levered beta*risk premium = 5% + 2.97*7% = 25.79%

Value of debt = $900 million

Value of equity = 21 million * $10 = $210 million

Total Value = $1110 million

E/V = 210/1110

D/V = 900/1110

Cost of capital for the company = (900/1110)*6.2% + (210/1110)*25.79% = 9.91%

b) New value of debt = $900 million - $225 million = $675 million

New value of equity = $210 million + $210 million = $420 million

New D/E = 675/420 = 1.61

Unlevered beta = Levered Beta/(1+(1-t)D/E) = 2.97/(1+ (1-0.38)*900/210) = 0.8121

New Levered Beta = Unlevered beta*(1+(1-t)D/E) = 0.8121*(1+0.62*1.61) = 1.62

New cost of equity = risk free rate + Levered beta*risk premium = 5% + 1.62*7% = 16.34%

New after-tax cost of debt = 7.5%*(1-0.38) = 4.65%

New cost of capital = (675/(675+420))*4.65% + (420/(675+420))*16.34% = 9.13%

c) Old firm value = $1110 million

Increase in firm value = (Old cost of capital - New cost of capital)*Old firm value/(New cost of capital - growth rate)

Increase in firm value = (9.91%-9.13%)*1110/(9.13%-1.9%) = $119.75

New firm value = Old firm value + Increase in firm value = $1110 million + $119.75 million

New value = $1229.75 million

New equity value =  $1229.75 million - $675 million = $554.75 million

Number of shares = 21 million + 21 million = 42 million

Value per share = $554.75 million/42 = $13.21

Ans: $13.21