Plastico, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions): Assets Liabilities Fixed assets $4,000 Debt $2,500 Current assets $1,000 Equity $2,500 In addition, you are provided the following information: • The debt is in the form of long-term bonds, with a coupon rate of 10%. The bonds are currently rated AA and are selling at a yield of 12% (the market value of the bonds is 80% of the face value). • The firm currently has 50 million shares outstanding, and the current market price is $80 per share. The firm pays a dividend of $4 per share and has a price/earnings ratio of 10. • The stock currently has a beta of 1.2. The riskfree rate is 8%. • The tax rate for this firm is 40% Plastico is considering a major change in its capital structure. It has three options: • Option 1: Issue $1 billion in new stock and repurchase half of its outstanding debt. This will make it an AAA-rated firm (AAA rated debt is yielding 11% in the marketplace). • Option 2: Issue $1 billion in new debt and buy back stock. This will drop its rating to A–. (A– rated debt is yielding 13% in the marketplace). • Option 3: Issue $3 billion in new debt and buy back stock. This will drop its rating to CCC (CCC rated debt is yielding 18% in the marketplace). a. What is the cost of equity under each option? b. What is the after-tax cost of debt under each option? c. What is the cost of capital under each option? d. What would happen to (i) the value of the firm; (ii) the value of debt and equity; and (iii) the stock price under each option if you assume rational stockholders? e. From a cost of capital standpoint, which of the three options would you pick, or would you stay at your current capital structure? f. What role (if any) would the variability in Plastico’s income play in your decision? g. How would your analysis change (if at all) if the money under the three options were used to take new investments (instead of repurchasing debt or equity)? h. What other considerations (besides minimizing the cost of capital) would you bring to bear on your decision? i. Intuitively, why doesn’t the higher rating in option 1 translate into a lower cost of capital?
Plastico, a manufacturer of consumer plastic products, is evaluating its capital
structure. The balance sheet of the company is as follows (in millions):
Assets Liabilities
Fixed assets $4,000 Debt $2,500
Current assets $1,000 Equity $2,500
In addition, you are provided the following information:
• The debt is in the form of long-term bonds, with a coupon rate of 10%. The bonds
are currently rated AA and are selling at a yield of 12% (the market
80% of the face value).
• The firm currently has 50 million shares outstanding, and the current market price
is $80 per share. The firm pays a dividend of $4 per share and has a price/earnings ratio
of 10.
• The stock currently has a beta of 1.2. The riskfree rate is 8%.
• The tax rate for this firm is 40%
Plastico is considering a major change in its capital structure. It has three options:
• Option 1: Issue $1 billion in new stock and repurchase half of its outstanding
debt. This will make it an AAA-rated firm (AAA rated debt is yielding 11% in the
marketplace).
• Option 2: Issue $1 billion in new debt and buy back stock. This will drop its
rating to A–. (A– rated debt is yielding 13% in the marketplace).
• Option 3: Issue $3 billion in new debt and buy back stock. This will drop its
rating to CCC (CCC rated debt is yielding 18% in the marketplace).
a. What is the
b. What is the after-tax cost of debt under each option?
c. What is the cost of capital under each option?
d. What would happen to (i) the value of the firm; (ii) the value of debt and equity;
and (iii) the stock price under each option if you assume rational stockholders?
e. From a cost of capital standpoint, which of the three options would you pick, or
would you stay at your current capital structure?
f. What role (if any) would the variability in Plastico’s income play in your
decision?
g. How would your analysis change (if at all) if the money under the three options
were used to take new investments (instead of repurchasing debt or equity)?
h. What other considerations (besides minimizing the cost of capital) would you
bring to bear on your decision?
i. Intuitively, why doesn’t the higher rating in option 1 translate into a lower cost of
capital?
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