Question

Caviar Fishfarm Ltd (‘CFL’) is unlevered, has an equity beta of 1.25 and unlevered cash flows of $76,800 per annum that will continue in perpetuity. The expected market return is 10%p.a and Treasury bills earn 2%p.a. CFL is currently considering issuing $300,000 in new debt with an 8% interest rate. CFL would repurchase $300,000 of its own shares, using the proceeds of the debt issue. There are currently 32,000 shares outstanding and the company’s effective marginal tax rate is 34%. Calculate the WACC (after tax) after the restructuring is complete.

Answer 1

GIVEN DATA:

CFL is unlevered and has an equity beta of 1.25. Therefore the initial debt component of CFL Capital Structure is zero.

CFL has unlevered cash flows of $76,800 per annum that will continue in perpetuity.

Expected Market Retrun = 10% p.a.

Treasury Bill Return = 2% p.a.

CFL's effective marginal tax rate = 34%

CFL has 32,000 shares outstanding

NEW CAPITAL STRUCTURING:

CFL to issue $300,000 in debt with 8% interest rate

CFL to repurchase $300,000 with the issued debt and

SOLUTION:

First, we find cost of equity and hence cost of capital for CFL's initial capital structure

cost of equity Ke is given by:

Ke = Rf + beta*(Rm - Rf)

where Rf is the risk free return (Return of T bills in this case) and Rm is the expected market return and beta is the beta of the CFL equity.

Therefore,

Ke = 2% + (1.25)(10% - 2%)

Ke = 12%

Now, we find the value of CFL by discounting the perpetuity unlevered cash flow of $76,800 p.a (equals P in the formula) with the cost of equity. this value would be the capital A of CFL. By using the present value of a perpetuity formula

A = P/Ke

A = $76,800/0.12

A = $640,000

Now, during the restructuring of CFL capital structure, CFL borrows $300,000 debt at 8% p.a. and buys back $300,000 of its equity.

Therefore, the Debt component D = $300,000 and Equity component E = $640,000 - $300,000 = $340,000.

The After tax cost of debt Kd = (1 - Marginal Tax rate)*(Interest on debt)

Therefore, Kd = (1-0.34)*(8%) = 5.28%

Therefore, after tax WACC after restructuring is given by:

WACC = (D/A)(Kd) + (E/A)(Ke)

WACC = (300,000/640,000)(5.28%) + (340,000/640,000)(12%)

WACC = 2.48% + 6.38%

WACC = 8.85%