Question

Ashman Motors is currently an​ all-equity firm. It has two million shares​ outstanding, selling for ​$37 per share. The company has a beta of 0.9​, with the current​ risk-free rate at 3.1​% and the market premium at 7.6​%. The tax rate is 25​% for the company. Ashman has decided to sell ​$37 million of bonds and retire half its stock. The bonds will have a yield to maturity of 7.4​%. The beta of the company will rise to 1.3 with the new debt. What was​ Ashman's adjusted WACC before selling the​ bonds? What is its new WACC after selling the bonds and retiring the stock with the proceeds from the sale of the​ bonds?  Hint​: The weight of equity before selling the bond is​ 100%.

What was​ Ashman's adjusted WACC before selling the​ bonds?

What is its new WACC after selling the bonds and retiring the stock with the proceeds from the sale of the​ bonds?

Answer 1

Solution:

a)Calculation of Ashman's adjusted WACC before selling the​ bonds

Cost of equity as per CAPM=Risk free rate+Beta(Market risk premium)

=3.1%+0.90*7.6%

=9.94%

Since the Ashman Motors is currently an​ all-equity firm,thus firm's capital structure consists of only equity.Threfore WACC is;

=Cost of equity*Weight of equity

=9.94%*100%=0.0994 or 9.94%

b)Due to issue of bond,equity's beta will need to recalculate.Further,weight of debt in capital structure shall be 50%,since company used the bond's proceed retire half its stock.

Asset Beta=Equity' Beta/[1+(1-tax rate)*Debt/Equity]

1.3=Equity' Beta/1+(1-0.25)*1

1.3=Equity' Beta/1.75

Equity Beta=1.3*1.75

=2.275

New Cost of equity=Risk free rate+Beta(Market risk premium)

=3.1%+2.275*7.6%

=20.39%

After tax cost of debt=YTM(1-tax rate)

=7.4%(1-0.25)

=5.55%

New WACC=Cost of equity*Weight of equity+After tax cost of debt*Weight of debt

=20.39%*0.50+5.55%*0.50

=12.97%