City Council Limited has 5 million shares outstanding, selling at $25 per share and there is no debt. The beta of the stock is 1.20, and its debt yielding 10%. The firm is proposing borrowing $25 million in debt and repurchasing stock. If it does so its interest rate of debt would become 12%. At the same time the beta of the stock will increase to 1.45. Assume a tax rate of 35% and debt beta of zero. The current risk-free rate is 9% and the market risk premium is 6.5%. Required: a) Calculate the company’s current weighted average cost of capital? b) Estimate the weighted average cost pf capital of the company following the introduction of debt (financial restructuring)? c) Estimate the new price of stock following the financial restructuring. d) Briefly explain the impact of increase in leverage on the expected return of equity holders.
City Council Limited has 5 million shares outstanding, selling at $25 per share and there is no debt. The beta of the stock is 1.20, and its debt yielding 10%. The firm is proposing borrowing $25 million in debt and repurchasing stock. If it does so its interest rate of debt would become 12%. At the same time the beta of the stock will increase to 1.45. Assume a tax rate of 35% and debt beta of zero. The current risk-free rate is 9% and the market risk premium is 6.5%.
Required:
a) Calculate the company’s current weighted average cost of capital?
b) Estimate the weighted average cost pf capital of the company following the introduction of debt (financial restructuring)?
c) Estimate the new price of stock following the financial restructuring.
d) Briefly explain the impact of increase in leverage on the expected return of equity holders.
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