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 the data for Best Bagels, Inc. (BB). 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?
A) $498,339
B) $512,188
C) $525,237
D) $540,239
E) $590,718

Question

Quizplus · Accepted Answer

$\begin{aligned}
\text { WACC } &=w_{c} r_{\mathrm{s}}+w_{\mathrm{d}}(1-T) r_{\mathrm{d}} \
&=(0.8)(0.14)+(0.2)(0.07)(1-0.4)=0.1204=12.04 \%
\end{aligned}$ 
 $\begin{aligned}
V &=F C F / W A C C . \text { Since } g=0, F C F=N O P A T=E B I T(1-T) \
V &=\$ 100,000(1-0.4) / 0.1204=\$ 498,338.87 \approx \$ 498,339
\end{aligned}$