Question

Omega Corporation has 10.9 million shares outstanding, now trading at $64 per share. The firm has estimated the expected rate of return to shareholders at about 15%. It has also issued long-term bonds at an interest rate of 6%. It pays tax at a marginal rate of 34%. Assume a $245 million debt issuance. a. What is Omega’s after-tax WACC? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Omega’s after-tax WACC % b. How much higher would WACC be if Omega used no debt at all? (Hint: For this problem you can assume that the firm’s overall beta [βA] is not affected by its capital structure or by the taxes saved because debt interest is tax-deductible.) (Do not round intermediate calculations. Round your answer to 2 decimal places.) WACC %

Answer 1

Number of shares outstanding = 10.90 million
Price per share = $64.00

Value of Equity = Number of shares outstanding * Price per share
Value of Equity = 10.90 million * $64.00
Value of Equity = $697.60 million

Value of Firm = Value of Debt + Value of Equity
Value of Firm = $245.00 million + $697.60 million
Value of Firm = $942.60 million

Weight of Debt = Value of Debt / Value of Firm
Weight of Debt = $245.00 million / $942.60 million
Weight of Debt = 0.2599

Weight of Equity = Value of Equity / Value of Firm
Weight of Equity = $697.60 million / $942.60 million
Weight of Equity = 0.7401

Answer a.

After-tax WACC = Weight of Debt * Cost of Debt * (1 - tax) + Weight of Equity * Cost of Equity
After-tax WACC = 0.2599 * 6.00% * (1 - 0.34) + 0.7401 * 15.00%
After-tax WACC = 12.13%

Answer b.

WACC = Weight of Debt * Cost of Debt + Weight of Equity * Cost of Equity
WACC = 0.2599 * 6.00% + 0.7401 * 15.00%
WACC = 12.66%

So, WACC will increase by 0.53% if Omega Corporation used no debt at all.