The Hifalutin Co. has perpetual EBIT of $3,000. It has no debt in its capital structure, and its cost of equity is 15%. The corporate tax rate is 40%. There are 300 shares outstanding. Hifalutin has announced that it will borrow $3,750 in perpetual debt at 8% and use the proceeds to buy up stock. A firm is all equity with 5,000 shares outstanding worth $7 each. They are planning on issuing $10,000 of new perpetual debt at the 8% market rate of interest. The effective tax rate is 25%. What is the change in equity value if they make the debt for equity exchange?
A) $.50 per share
B) $200
C) $800
D) $.16 per share

Question

Quizplus · Accepted Answer

The correct answer is A. The change in equity value is $.50 per share. This is because the company will be taking on $3,750 of debt at 8%, which will increase its interest expense by $300. This will reduce its EBIT by $300, which will in turn reduce its equity value by $300 / (1 - 0.4) = $500. Since there are 300 shares outstanding, this works out to a change in equity value of $500 / 300 = $.50 per share.