O’Connell & Co. expects its EBIT to be $42,000 every year forever. The firm can borrow at 6 percent. O’Connell currently has no debt, and its cost of equity is 10 percent and the tax rate is 35 percent. The company borrows $108,000 and uses the proceeds to repurchase shares. What is the cost of equity after recapitalization?

Cost of equity after recapitalization is 8.5%

Explanation:

As net income is associated with the equity holders, we can say that the equity net income can determine the cost of equity.

First Calculate the net income

EBIT              $42,000

Interest         $0        

EBT               $42,000

Tax 35%       $(14,700)

Net Income  $27,300

Cost of equity = Net income / Equity value

10% = $27,300 / Equity value

Equity Value = $27,300 / 10% = $273,000

After Recapitalization

EBIT              $42,000

* Interest       $(6,480)

EBT               $35,520

Tax 35%       $(12,432)

Net Income  $23,088

* Interest Expense = $108,000 x 6% = $6,480

Cost of equity = Net income / Equity value

Cost of equity = 23,088 / $273,000 = 8.5%

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