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You have been asked to analyse the capital structure of Fairly Large Company Inc (FLC), and make recommendations on a future course of action. FLC has 40 million shares outstanding, selling at $20 per share and a debt-equity ratio (in market value terms) of 0.25. The beta of the stock is 1.20, and the firm currently has a A rating, with a corresponding market interest rate of 6%. The firm's income statement is as follows: EBIT $150 million Interest Exp. $ 20 million Taxable Inc. $130 million Taxes $ 52 million Net Income $ 78 million The current risk free rate is 4% and the market risk premium is 5.5%.
Questions:
a. What is the firm's current weighted average cost of capital?
b. The firm is proposing borrowing an additional $200 million in debt and repurchasing stock. If it does so its rating will decline to BB+, with a market interest rate of 8%. What will the Weighted average cost of capital (WACC) be if they make this move?
c. What will the new stock price be if they borrow $200 million and repurchase stock (assuming rational investors)? (You may assume a growth perpetuity to compute the change in firm value)
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