Question

For the most recent fiscal year, book value of long-term debt at Schlumberger was $11962 million. The market value of this long-term debt is approximately equal to its book value. Schlumberger’s share price currently is $59.03. The company has 1,000 million shares outstanding. Managers at Schlumberger estimate that the yield to maturity on any new bonds issued by the company will be 8.46%. Schlumberger’s marginal tax rate would be 35%. Schlumberger’s beta is 0.89. Suppose that the expected return on the market portfolio is 8% and the risk-free rate is 2%. Assume that the company will not change its capital structure. Also assume that the business risk of the projects under consideration is about the same as the business risk of Schlumberger as a whole. What would Schlumberger’s after-tax WACC be, given this information? Do not round at intermediate steps in your calculation. Express your answer in percent. Round to two decimal places. Do not type the % symbol.

Answer 1

Schlumberger’s after-tax Weighted Average Cost of Capital (WACC)

Market Value capital structures

Market Value of Debt = $11,962 Million

Market Value of Equity = $59,030 Million [1,000 Million shares x $59.03 per share]

Total Market Value = $70,992 Million

Weight of Capital Structure

Weight of Debt = 0.1685 [$11,962 Million / $70,992 Million]

Weight of Equity = 0.8315 [$59,030 Million/ $70,992 Million]

After-tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 8.46% x (1 – 0.35)

= 8.46% x 0.65

= 5.50%

Cost of Equity

As per CAPM Approach, the Cost of Equity = Risk-free Rate + Beta[Market rate of return – Risk-free rate]

= Rf + B[Rm – Rf]

= 2.00% + 0.89[8.00% - 2.00%]

= 2.00% + [0.89 x 6.00%]

= 2.00% + 5.34%

= 7.34%

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [5.50% x 0.1685] + [7.34% x 0.8315]

= 0.93% + 6.10%

= 7.03%

“Hence, Schlumberger’s after-tax Weighted Average Cost of Capital (WACC) will be 7.03%”