Question

Omega Corporation has 11.7 million shares outstanding, now trading at $48 per share. The firm has estimated the expected rate of return to shareholders at about 10%. It has also issued $165 million of long-term bonds at an interest rate of 9%. It pays tax at a marginal rate of 34%.

a. What is Omega’s after-tax WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) After-tax WACC = _______%

b. What would WACC be if Omega used no debt at all? (Hint: For this problem you can assume that the firm’s overall beta [βA] is not affected by its capital structure or by the taxes saved because debt interest is tax-deductible.) (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) WACC = ________%

Answer 1

Solution:
a.	After tax WACC      9.08%
Working Notes:
	For After tax WACC
	Returns required for investor of debt only needed tax adjustment , common stock required rate of return are already after tax so it does not required further adjustment.
	The cost of debt is 9% = the interest rate
	After tax cost of debt (Kd) = Cost of debt x (1- tax rate)
	After tax cost of debt (Kd) = 9% x (1- 0.34)
	After tax cost of debt (Kd) = 9% x 0.66
	After tax cost of debt (Kd) = 5.94%
	Cost of common equity (Ke)=10%   (Given)
	WACC= Ke x E/V   + Kd   x D/V
	Total value of equity E = no of share outstanding x current share price
	Total value of equity E = 11.7 million x 48
	Total value of equity E = $561.6 million
	Value of debt D= $165 million
	V= total value of capital structure = D + E = 561.6 + 165 = 726.6
Notes:	To calculate market value of bond we need market interest rate so, it is basic assumption than given book value debt is market value of debt
	WACC= Ke x E/V   + Kd   x D/V
	=10% x (561.60/726.60) + 5.94% x (165/726.60)
	=0.090780347
	=9.08%
b.	WACC   9.77%
Working Notes:
	If company does not use debt at all, and beta does not changed means , company will not able to get benefit of tax saving on interest expense and firm able to capital of 165 million of debt at cost 9% as beta of assets is not changing
	In short the company will not able to get benefit of tax saving on interest expense and its overall WACC will increase
	The cost of debt is 9% = the interest rate
	After tax cost of debt (Kd) =9%
	Cost of common equity (Ke)=10%   (Given)
	WACC= Ke x E/V   + Kd   x D/V
	Total value of equity E = no of share outstanding x current share price
	Total value of equity E = 11.7 million x 48
	Total value of equity E = $561.6 million
	Value of debt D= $165 million
	V= total value of capital structure = D + E = 561.6 + 165 = 726.6
	To calculate market value of bond we need market interest rate so, it is basic assumption than given book value debt is market value of debt
	WACC= Ke x E/V    + Kd   x D/V
	=10% x (561.60/726.60) + 9% x (165/726.60)
	=9.77291494
	=9.77%
	9.77%
Please feel free to ask if anything about above solution in comment section of the question.