Exhibit 16.3
Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. BB's current cost of equity is 13%, and its tax rate is 40%. The firm has 20,000 shares of common stock outstanding selling at a price per share of $23.08.
-Refer to Exhibit 16.3.BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity,based on market values.The debt would have an interest rate of 7%.The new funds would be used to repurchase stock.It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise to 14%.If this plan were carried out,what would BB's new value of operations be?

Question

Quizplus · Accepted Answer

The correct answer is A.The new value of operations is the present value of the future cash flows of the firm. The future cash flows are the EBIT minus the interest expense, multiplied by the tax rate. The present value of these cash flows is calculated using the WACC, which is the weighted average cost of capital. The WACC is calculated as the cost of equity multiplied by the proportion of equity in the capital structure, plus the cost of debt multiplied by the proportion of debt in the capital structure. In this case, the WACC is 13% * 0.8 + 7% * 0.2 = 10.6%. The present value of the future cash flows is therefore $100,000 * (1 - 0.07) * 0.4 / 0.106 = $498,339.

Exhibit 16.3 Best Bagels, Inc. (BB) Currently Has Zero Debt. Its Earnings