Question

In: Finance

(A) Income for Caldwell Instruments is sufficiently high that if it increases its income by adopting...

(A)

Income for Caldwell Instruments is sufficiently high that if it increases its income by adopting a new project, then its marginal corporate income tax rate is 38%. Managers at Caldwell estimate that if the company issues bonds to help finance a new project, the yield required by investors will be 12.02% What is the after-tax cost of debt for Caldwell? Do not round at intermediate steps in your calculation. Express your answer in percent. Round to two decimal places. Do not type the % symbol.

(B)

For the most recent fiscal year, book value of long-term debt at Schlumberger was $14,691 million. The market value of this long-term debt is approximately equal to its book value. Schlumberger’s share price currently is $53.76. The company has 1,000 million shares outstanding.

Managers at Schlumberger estimate that the yield to maturity on any new bonds issued by the company will be 8.78%. Schlumberger’s marginal tax rate would be 35%.

Schlumberger’s beta is 0.87. Suppose that the expected return on the market portfolio is 8% and the risk-free rate is 2%.

Assume that the company will not change its capital structure. Also assume that the business risk of the projects under consideration is about the same as the business risk of Schlumberger as a whole.

What would Schlumberger’s after-tax WACC be, given this information?

Solutions

Expert Solution

A]

after-tax cost of debt = YTM of bond * (1 - tax rate)

after-tax cost of debt = 12.02% * (1 - 38%) = 7.45%

B]

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

cost of equity = risk free rate + (beta * (expected market return - risk free rate))

cost of equity = 2% + (0.87 * (8% - 2%)) ==> 7.22%

after-tax cost of debt = YTM of bond * (1 - tax rate)

after-tax cost of debt = 8.78% * (1 - 35%) = 5.707%

market value of debt = $14,691 million

market value of equity = 1,000 million * $53.76 = $53,760 million

total market value = $14,691 million + $53,760 million = $68,451 million

weight of debt = market value of debt / total market value

weight of debt = $14,691 million / $68,451 million  

weight of equity = market value of equity / total market value

weight of equity = $53,760 million / $68,451 million

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)

WACC = (($14,691 million / $68,451 million) * 5.707%) + (($53,760 million / $68,451 million) * 7.22%)

WACC = 6.90%

jeff jeffy answered 1 year ago
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