Zanshu Ltd. is an all equity financed company with a market value of 25,00,000 and cost of equity (K e ) 21%. The company wants to buyback equity…

Net income (NI) for equity holders = Market Value of Equity × K e Net income (NI) for equity holders = 25,00,000 × 0.21 = 5,25,000 EBIT = Net income for equity holders / (1 - Tax Rate) = 5,25,000 / (1 - 0.30) = 5,25,000 / 0.7 = 7,50,000 (i) Value of Restructured firm Present value of tax-shield benefits = 5,00,000 × 0.30 = 1,50,000 Value of Restructured firm = Value of Unlevered Firm + PV of Tax Shield = 25,00,000 +1,50,000 = 26,50,000 (ii) Cost of Equity (K e ) Total Value = 26,50,000 Less: Value of Debt = 5,00,000 Value of Equity = 21,50,000 Income available to equity shareholders = EBIT - Interest (1-Tax Rate) Interest on debt = 15% of 5,00,000 = 75,000 Income available to equity shareholders = 7,50,000 -75,000 = 6,75,000 Less: Taxes (30%) = 6,75,000 × 0.30 = 2,02,500 Income available to equity shareholders (PAT) = 6,75,000 -2,02,500 = 4,72,500 K e = Income available to equity shareholders / Value of Equity K e = 4,72,500 /21,50,000 = 0.219767 ≈ 21.98% (iii) WACC (on market value weight) Cost of Debt (after tax) = 15% (1-0.3) = 0.15 (0.70) = 0.105 = 10.5% Components of Costs Amount Cost of Capital (%) Weight WACC (%) Equity 21,50,000 21.98 0.81 17.80 Debt 5,00,000 10.50 0.19 2.00 26,50,000 19.80 Comment: At present the company is all equity financed. So, K e = K o i.e. 21%. However, after restructuring, the K o would be reduced to 19.80% and K e would increase from 21% to 21.98%.