Question

1. Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11 percent. Bruce currently has no debt, and its cost of equity is 18 percent. The tax rate is 31 percent. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization

   		16.30 percent
   		16.87 percent
   		17.15 percent
   		18.29 percent

Answer 1

Value of unlevered firm = [EBIT (1 -tax) / required rate

Value of unlevered firm = [100,000(1 - 0.31)] / 0.18

Value of unlevered firm = 383,333.33

Value of levered firm = Value of unlevered firm + tax(debt)

Value of levered firm = 383,333.33 + 0.31(61,000)

Value of levered firm = 402,243.33

Debt = 61,000

Equity = 402,243.33 - 61,000 = 341,243.33

Debt-equity ratio = Debt / equity

Debt-equity ratio = 61,000 / 341,243.33

Debt-equity ratio = 0.1788

Cost of levered equity = Cost of uneleverd equity + (cost of unlevered equity - cost of debt)(1 - tax)debt-equity ratio

Cost of levered equity = 0.18 + (0.18 - 0.11)(1 - 0.31)0.1788

Cost of levered equity = 0.18 + 0.0086

Cost of levered equity = 0.1886 or 18.86%

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

WACC = [341,243.33 / (61,000 + 341,243.33)]*0.1886 + [61,000 / (61,000 + 341,243.33)]*0.11*(1 - 0.31)

WACC = 0.16 + 0.0115

WACC = 0.1715 or 17.15%