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Benson, Athavale & Kemper (BAK) started a manufacturing facility in the last century. This firm, profitable since inception produces steering units for the automotive industry. The 3 founders have been averse to debt.
Presently, BAK has 20 million shares outstanding trading at $ 25.
The CFO Dawn Strong is looking at a proposal to buyout a competitor for $ 100 million. The entrepreneurs expect pre-tax earnings to increase by $ 20 million in perpetuity. Dawn computes the cost of capital to be 10%. She is a recent graduate from a MBA program and knows that some debt will increase the value of the firm and she plans to evaluate this project by borrowing the required funds.
Dawn finds out that the firm can sell 30 year AAA bonds with a 6% coupon. She opines that the firm with a capital structure around 25% debt will help increase its value and not worry the shareholders or the financial markets.
The firm is in the 40% tax bracket.
Should BAK accept the project? With debt or with sale of shares? Explain?
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