Question

ExxonMobil has historically had a very low debt-to-equity ratio within the oil industry, but it recently issued $12 billion in new debt to raise capital to buy up distressed rivals. The cost of this debt turns out to have been around 2%. In this problem we'll calculate how this bond issuance may have affected ExxonMobil's cost of capital.

For the sake of this problem, assume that ExxonMobil was an unlevered firm prior to this debt issuance (at the time of the above mentioned debt issuance the debt-to-equity ratio of ExxonMobil was just over 0.1, so ExxonMobil was pretty unlevered at the time). The equity beta of ExxonMobil is 0.85, the risk-free rate of return is 0.5% and the market risk premium is 4%. The EBIT for ExxonMobil is $15 billion, which you can assume will remain constant in perpetuity. The tax rate is 35%, and earnings after taxes are paid out entirely as dividends.

Your task in this problem is to calculate the WACC for ExxonMobil before and after the bond issuance.

Answer 1

1) WACC before bond issuance

WACC = (Cost of equity x weight of equity + cost of debt (1-tax) x weight of debt)

= 3.9%

WACC will be equal to cost of equity in this case as there is no debt issue.

Notes:

a) Calculation of cost of equity

Cost of equity could be found out using capital asset pricing model

Using CAPM we have,

Rf + Beta x Market risk premium

0.5% + 0.85 * 4%

= 3.9%

b) Cost of debt

Cost of debt will be nil as there is no debt issue

2) WACC after bond issuance

WACC = (Cost of equity x weight of equity + cost of debt (1-tax) x weight of debt)

= (3.9% x 0.9) + (2% x 0.1)

= 3.51% + 0.2%

= 3.71%

Notes:

a) Calculation of cost of equity

Cost of equity could be found out using capital asset pricing model

Using CAPM we have,

Rf + Beta x Market risk premium

0.5% + 0.85 * 4%

= 3.9%

b) Cost of debt

In the question itself, cost of debt is given to be 2%. Here we can assume that the cost of debt given is already adjusted for tax hence we will not deduct the tax from this cost of debt.

Hence, cost of debt will be 2% only as given in question