Question One 

Energy Star plc is an international company in the UK, renowned for being a key player in the digital technology development conducts. Over the last 2 years the company has faced fierce competition from some European countries and this has had a significant impact on the value of the company. The company is financed by both equity and debt. The debt equity ratio of Energy Star plc is 1. The Total Assets of the company accounts for £7,000 (in millions).  

The debt is in the form of long term bonds, with a coupon rate of 12%. The bonds are currently rated AA and are selling at a yield of 11%. 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 £4.5 per share and has a price/earnings ratio of 12. The stock currently has a beta of 1.35. The six-month Treasury bill rate is 6.5%. The market risk premium is 5.5%. The tax rate for this company is 35%.  

Energy Star plc is evaluating its capital structure and considering a major change in its capital structure. It has the following three options: 

Option 1: Issue £1.5 billion in new stock and repurchase half of its outstanding debt. This will make it an AAA rated company. AAA rated debt is yielding 12% in the market place. 

Option 2: Issue £1.5 billion in new debt and buy back stock. This will drop its rating to A-. A-rated debt is yielding 13.8% in the market place. 

Option 3: Issue £2.5 billion in new debt and buy back stock. This will drop its rating to CCC CCC rated debt is yielding 17.5% in the market place. 

Calculate the cost of equity, after-tax cost of debt and the cost of capital under each option. From a cost of capital standpoint, explain which of the three options would the company pick, or the company would stay at its current capital structure.