Barnes Baskets, 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.
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?
Now assume that BB is considering changing from its original capital structure to a
new capital structure with 45% debt and 55% equity. This results in a weighted
average cost of capital equal to 10.4% and a new value of operations of $576,923.
Assume BB raises $259,615 in