Extra Practice Problem on computing WACC
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US Online provides internet access to consumers in continental
US. The firm has (i) 100,000 shares outstanding; and (ii) $ 2 mm of
debt yielding 10% p.a. in its capital structure. Its shares are
listed on NASDAQ and trade at a price of $ 20, and the firm will have
EBIT of $450,000 p.a. to perpetuity. Assume that the corporate tax
rate is zero.
1. Compute the required rate of return for (the levered) US Online equity. 2. Compute the WACC for US Online. 3. Suppose US Online decides to unlever by issuing equity and retiring all its outstanding debt. What would be the new required rate of return for its equity? 4. Do you think US Online ought to unlever in light of your answers to parts (1) and (3)? Explain your answer. 5. Compute US Online's earnings per share [EPS] when (i) it was levered; and (ii) when it is unlevered. What is wrong with the following argument? US Online's EPS is higher when it is levered. Hence, the firm should lever up, in order to maximize shareholder value.