Question

You have the following data for ABM Corp. The market value of equity is $300M, and the market value of debt is 90M. The company is considering repurchasing its bonds for $20M and issuing common stock for the same amount. This would move beta to 1.29 and after-tax cost of debt to 7%. Estimate new WACC if risk-free rate is 4.7% and the return on stock market is 9.2%. The company pays 22% taxes on its profits.

Answer 1

WACC = Rs x Ws + Rd (1-T) x Wd

In order to calculate WACC, we will multiply cost of each component of capital with its respective weight.

In the given formula,

· Rs = cost of equity

· Rd = cost of debt

· Ws= weight of equity i.e. Market Value of firm's Equity / Total market value of firm's financing ( Percentage of financing through equity)

· Wd = weight of debt i.e. Market Value of firm's long-term debt / Total market value of firm's financing ( Percentage of financing through long-term debt)

· T = corporate tax rate

Here to calculate cost of equity, we will use CAPM, which is as follows:-

CAPM Model-

Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return)

Weight of each component can be found out by dividing the market value of that component/ total market value of firm's financing

Total market value of firm's financing = Market Value of Equity + Market Value of Preferred stock + Market Value of Long-term Debt + Market Value of Short-term Debt.

So, Weighted Average Cost of Capital = 9.8741% OR 9.87%