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Diablo Steel is a highly levered company with 21 million shares, trading at $11/share and $900 million in debt (in market and book value terms) outstanding. The pre-tax cost of debt for the company is 10%, the marginal tax rate is 40% and the levered beta for the company is 3.08. The risk free rate is 4% and the equity risk premium is 6%.
a. Estimate the cost of capital for the company
b. A bondholder in the firm is willing to accept 21 million newly issued shares in the company in exchange for $225 million in debt (which will be retired). This transaction will raise the company’s bond rating to BBB and lower their pre-tax cost of debt to 7.5%. Estimate the new cost of capital, if you go through with the swap.
c. Assuming that you go through with the swap of equity for debt (from part b), estimate the value per share after the transaction. (You can assume that the firm is in perpetual growth, growing 2% a year forever)
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