Best Bagels, Inc. (BB)

Best Bagels, Inc. (BB) currently has zero debt. Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company. BB’s current cost of equity is 13%, and its tax rate is 25%. The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

Refer to the data for Best Bagels, Inc. (BB). 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 8.2%. 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 13.9%. If this plan were carried out, what would BB's new value of operations be?

Question

Best Bagels, Inc. (BB)

Best Bagels, Inc. (BB) currently has zero debt.  Its earnings before interest and taxes (EBIT) are $130,000, and it is a zero growth company.  BB’s current cost of equity is 13%, and its tax rate is 25%.  The firm has 30,000 shares of common stock outstanding selling at a price per share of $25.

Refer to the data for Best Bagels, Inc. (BB). 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 8.2%.  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 13.9%. If this plan were carried out, what would BB's new value of operations be?

BlackTom AI · Accepted Answer

Value of operations equals the perpetual after-tax EBIT divided by the firm’s weighted average cost of capital (WACC): V = EBIT(1 − T) / WACC.

Relevant concepts:
- For a zero-growth (perpetuity) firm, value of operations = after-tax EBIT / WACC.
- WACC = rE*(E/V) + rD*(D/V)*(1 − Tc) where rE is cost of equity, rD cost of debt, Tc tax rate, and D/V and E/V are market-value capital structure weights.
- Modigliani–Miller with taxes gives an alternative: VL = VU + Tc·D, which yields the same result when D is a fixed fraction of VL; both methods can verify the answer.

Step-by-step calculation (WACC method):
1. After-tax EBIT = EBIT*(1 − T) = $130,000*(1 − 0.25) = $130,000*0.75 = $97,500.
2. Capital structure weights: D/V = 0.20, E/V = 0.80.
3. New required return on equity rE = 13.9% = 0.139. Cost of debt rD = 8.2% = 0.082. After-tax cost of debt = 0.082*(1 − 0.25) = 0.082*0.75 = 0.0615.
4. WACC = 0.80*0.139 + 0.20*0.0615 = 0.1112 + 0.0123 = 0.1235 (12.35%).
5. Value of operations = 97,500 / 0.1235 = 789,473.684 ≈ $789,474.

Alternative (MM with taxes) quick check:
- Unlevered value VU = 97,500 / 0.13 = $750,000 (using current rE = 13% when no debt).
- If VL = VU + Tc·D and D = 0.20·VL, then VL = 750,000 + 0.25*(0.20*VL) = 750,000 + 0.05·VL ⇒ 0.95·VL = 750,000 ⇒ VL = 750,000/0.95 = 789,473.684 ≈ $789,474. Matches WACC result.

Why this choice is correct:
The computation uses the provided new equity cost (13.9%), the after-tax debt cost, and the 20/80 market-value weights to get WACC, then values the perpetual after-tax EBIT. The MM check confirms consistency.

Why other options are incorrect (brief):
- $821,053, $888,051, $853,895, $923,573 do not satisfy the correct WACC or MM-with-taxes algebra above; they result from incorrect weights, wrong tax treatment, or using pretax debt cost rather than after-tax cost.

Final answer confirmed: $789,474.

类似问题

The following data are available for Halcyon Industries at several capital structures. Based on this information, what is the firm's optimal capital structure? Debt Equity EPS Stock Price 20% 80% $2.40 $24.00 30% 70% $2.68 $25.80 40% 60% $2.95 $27.10 50% 50% $3.20 $26.50 60% 40% $3.44 $25.20

According to Modigliani and Miller, in a world with no corporate taxes a firm cannot change its total value by altering the proportions of debt and equity in its capital structure.

Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ____.

Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.

According to M&M Proposition 2, the cost of a company's equity[Fill in the blank]

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