Question

ABC corporation's CFO decided to reevaluate its capital structure. Currently, ABC's stock trades for $30 a sHARE, AND 1 BILLION SHARES ARE OUTSTANDING. ABC's market value of debt is $10 billion. we do not have any coupon or yield-to maturity information for ABC's debt. we also information on ABC's bond rating! However, ABC's beta is 1.2. ABC's income statement shows that its marginal tax rate is 35, its EBIT is 51.5 billion, and total interest paid currently is $300 million. At the moment risk- free rate is 3% and market risk premium is 5%. The CFO wants to compare ABC's current capital structure with the proposed 50-50 (Debt/equity) capital structure and select the better one. CFO assumes that the new debt will have the same cost of Debt ABC currently has. Please assume the role of CFO and show which capital structure should be selected?

Answer 1

Answer:

At Current capital structure:

Cost of equity = Risk free rate + Beta * Market risk premium = 3% + 1.2 * 5% = 9%

Cost of debt = Interest /Value of debt = 300 / 10,000 = 3%

Debt value = $10 billion

Equity value = $30 * 1 billion = $30 billion

Total value = 10 + 30 = $40 billion

Current WACC = 9% * 30/40 + 3% * (1-35%) * 10/40

= 7.2375%

Current WACC = 7.2375%

Proposed capital structure = 50-50 (Debt/equity)

Cost of debt remains same at = 3%

Unlevered beta = Levered Beta / (1 + (1 - Tax rate) * debt / equity)

= 1.2 / (1 + (1- 35%) *10/30)

= 0.986301

Levered beta at proposed capital structure = Unlevered beta * (1 + (1- 35%) *10/30) = 0.986301 * (1 + (1 - 35%) * 50%/50%)

= 1.62739665

Cost of equity = 3% + 1.62739665 * 5% = 11.14%

WACC = 11.14% * 50% + 3% * (1 - 35%) * 50%

= 6.545%

WACC at proposed capital structure = 6.545%

Capital structure which has lower WACC will also result in higher value of the company. Since WACC at proposed capital structure will be lower than WACC at current capital structure, proposed 50-50 (Debt/equity) capital structure should be selected.