Weighted Average Cost of Capital and Gentry Motors Inc.

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2 Gentry Motors Inc., a producer of turbine generators, is in this situation: EBIT _ $4 million; tax rate (T) is 35%; debt outstanding (D) $2 million; kd 10%; ke 15%; shares of stock outstanding (N0) 600,000; and book value per share $10. Since Gentry’s product market is stable and the company expects no growth, all earnings are paid out as dividends. The debt consists of perpetual bonds. a. What are Gentry’s earnings per share (EPS) and its price per share (P0)? b. What is Gentry’s weighted average cost of capital (WACC)? c. Gentry can increase its debt by $8 million, to a total of $10 million, using the new debt to buy back and retire some of its shares at the current price. Its interest rate on debt will be 12 percent (it will have to call and refund the old debt), and its cost of equity will rise from 15 percent to 17 percent. EBIT will remain constant. Should Gentry change its capital structure?

d. If Gentry did not have to refund the $2 million of old debt, how would this affect things? Assume that the new and the still outstanding debt are equally risky, with kd 12%, but that the coupon rate on the old debt is 10 %.

e. What is Gentry’s interest coverage ratio under the original situation and under the conditions in Part c of this question?
Combined Leverage
1 Weepyrow Limited manufactures recharageable batteries used in pocket calculators. In 2007 the company sold 50000 batteries at Rs. 20 per piece. The company’s profit and loss account for the year ended 31st December 2007 is as given below: Sales Rs. 10,00,000

Less: Variable Cost 400,000
Less: Fixed Cost 200,000 600,000
EBIT (Operating Profit) 400,000
Less: Interest 125,000
EBT 275,000
Less: Income Tax @ 40% 110,000
EAT 165,000
EPS (100,000 equity shares) 1.6
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