Question

Use the following information:

• Debt: $80,000,000 book value outstanding. The debt is trading at 95% of book value. The yield to maturity is 9%.
• Equity: 3,000,000 shares selling at $47 per share. Assume the expected rate of return on Federated’s stock is 18%.
• Taxes: Federated’s marginal tax rate is T_c = 0.21.

Suppose Federated Junkyards decides to move to a more conservative debt policy. A year later, its debt ratio is down to 13.75% (D/V = 0.1375). The interest rate has dropped to 8.6%. The company’s business risk, opportunity cost of capital, and tax rate have not changed.

Use the three-step procedure to calculate Federated’s WACC under these new assumptions.

(Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Book value of debt = $80,000,000

• Market price of Debt is 95% of book value

= $80,000,000 * 95%

= $76,000,000

Equity: 3,000,000 shares selling at $47 per share

Market value of equity = 3,000,000 * $47 = $141,000,000

• Total market value of debt and equity

= $76,000,000 + $141,000,000

= 217,000,000

The new debt equity ratio = 13.75%

• The new debt value

= 217,000,000 * 13.75%

= $29,837,500

As Federated Junkyards decides to move to a more conservative debt policy, it is assumed that the company utilized its retained earnings to reduce the debt.

Retained earnings utilized = $76,000,000 - $29,837,500 = $46,162,500

• Earnings available for equity stock holders

= (Market value of equity * expected rate of return on equity) + Interest surplus on release of debt

= ($141,000,000 * 18%) + ($46,162,500 * 9%)

= $25,380,000 + $4,154,625

= $29,531,625

• The new cost of equity

= earnings available for equity share holder / (equity value + retained earnings)

= $29,531,625 / (($141,000,000 + $46,162,500)

= $29,531,625 / $187,162,500

= 0.15778 i.e. 15.78%

Three steps for WACC:

• Step I: After tax cost of debt

= interest rate x (1-tax rate) = 8.6 * (1-0.34) = 5.676%

• Step II: Debt equity weight: Debt ratio

= 13.75%, Equity ratio

= 86.25% (100-13.75)

• Step III: WACC

= (After tax cost of debt * debt weight) + (cost of equity x equity weight)

= (5.676 x 13.75%) + (15.78 x 86.25%)

= 14.39 %

Hence WACC is 14.39%