Jim Campbell is founder and CEO of OpenStart, an innovative
software company. The company is all equity financed, with 100 million shares
outstanding. The shares are trading at a price of $1. Campbell currently owns
20 million shares. There are two possible states in one year. Either the new
version of their software is a hit, and the company will be worth $160€Â
million, or it will be a disappointment, in which case the value of the company
will drop to $75 million. The current risk free rate is 2%. Campbell is
considering taking the company private by repurchasing the rest of the
outstanding equity by issuing debt due in one year. Assume the debt is
zero-coupon and will pay its face value in one year.
a. What is the market value of the new debt that must be
issued?
b. Suppose OpenStart issues risk-free debt with a face value
of $75 million. How much of its outstanding equity could it repurchase with the
proceeds from the debt? What fraction of the remaining equity would Jim still
not own?
c. Combine the fraction of the equity Jim does not own with
the risk-free debt. What are the payoffs of this combined portfolio? What is
the value of this portfolio?
d. What face value of risky debt would have the same payoffs
as the portfolio in (c)?
e. What is the yield on the risky debt in (d) that will be
required to take the company private?
f. If the two outcomes are equally likely, what is
OpenStart’s current WACC (before the transaction)?
g. What is OpenStart’s debt and equity cost of capital after
the transaction? Show that the WACC is unchanged by the new leverage.