The Cramden Bus Company is currently all equity financed, but it is co

The Cramden Bus Company is currently all equity financed, but it is considering a leveraged capital structure, the details of which are presented in the table under the column labeled ‘Proposed’.

Assume that the company generates perpetual annual EBIT. Assume that all cash flows occur at the end of the year and we are currently at the beginning of a year. Assume that taxes are zero. Assume that all of net income is paid out as a dividend. Assume that the debt is perpetual with annual coupons (and yield) of 4%.
If Cramden recapitalizes, it will use the borrowed funds to repurchase (and cancel) shares. Determine both the value of the company and the value of the company’s equity if it recapitalizes.

Capital Structure Capital Structure
Current Proposed
EBIT $115,000 $115,000
Debt, D $0 $690,000
Cost of Debt, kd 4%
Cost of Equity 5%

A) Company value: $2,875,000; Equity value: $2,185,000
B) Company value: $2,875,000; Equity value: $2,875,000
C) Company value: $2,185,000; Equity value: $2,185,000
D) Company value: $2,300,000; Equity value: $1,610,000
E) Company value: $2,300,000; Equity value: $2,990,000

ANSWER

D