Contron Corp
Subject:FinancePrice: Bought3
Contron Corp. is currently an all-equity firm that currently has assets worth $200 million. On average, the return on the assets (ROA) every year is 16 percent. That is, on average, EBIT is 16 percent of the value of the assets. However, there are fluctuations in the annual return such that the beta of the ROA is 1.25. The marginal corporate tax rate for Contron Corp. is .25 (i.e., 25%). The personal tax rate of dividend and capital gains distributions is equal to that for interest income for debt; both types of tax rates are 28 percent. The firm currently has 10,000,000 shares outstanding.
The management of Contron Corp. is thinking about doing a leverage re-capitalization whereby it raises $40 million in debt at an interest rate of 2 percent and uses all of the proceeds of the sale of the debt to repurchase shares from current equity holders. Once it does this debt/repurchase transaction, the fluctuations in the EBIT are such that Contron Corp. can always afford to make its debt payments. Thus, the interest rate on the debt is the risk-free rate.
The risk-free rate is .02 and the expected return on the market is .10.
Questions:
- According to CAPM, what is the required rate of return on the firm's assets prior to the leveraged re-capitalization? What is the firm's weighted average cost of capital prior to the leveraged re-cap? (2 points)
- Prior to the re-capitalization, what is the value of the firm? What is the value of equity?
Firm Value: ___________________________ Equity Value: ___________________________
- After the re-capitalization, what is the total value of the firm?
- After the re-capitalization, what is the total value of the equity?
- Did the equity holders gain or lose with this re-capitalization? How and why?
- What is the expected return on the equity of the re-capitalized firm?
- What is the weighted average cost of capital after re-capitalization?
8. Why did the weighted average cost of capital change in the direction it changed?
