Question

Use the following information:

• Debt: $69,000,000 book value outstanding. The debt is trading at 95% of book value. The yield to maturity is 10%.
• Equity: 1,900,000 shares selling at $36 per share. Assume the expected rate of return on Federated’s stock is 19%.
• Taxes: Federated’s marginal tax rate is T_c = .35.

Suppose Federated Junkyards decides to move to a more conservative debt policy. A year later its debt ratio is down to 16.50% (D/V = .165). The interest rate has dropped to 9.6%. The company’s business risk, opportunity cost of capital, and tax rate have not changed.

Use the three-step procedure to calculate Federated’s WACC under these new assumptions. (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Weighted-average cost of capital             %  

Answer 1

Current D/E calc.

MV of equity=Price of equity*number of shares outstanding

MV of equity=36*1900000

=68400000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*69000*0.95

=65550000

MV of firm = MV of Equity + MV of Bond

=68400000+65550000

=133950000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 68400000/133950000

W(E)=0.5106

Weight of debt = MV of Bond/MV of firm

Weight of debt = 65550000/133950000

W(D)=0.4894

D/E = 0.4897/0.5106=0.959

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

19 = Unlevered cost of equity+0.959*(Unlevered cost of equity-10)*(1-0.35)

Unlevered cost of equity = 15.54

New D/E

D/A =0.165

D/E=D/(A-D)=0.165/(1-0.165)=0.1976

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 15.54+0.1976*(15.54-9.6)*(1-0.35)

Levered cost of equity = 16.3

Weight of equity = 1-D/A

Weight of equity = 1-0.165

W(E)=0.835

Weight of debt = D/A

Weight of debt = 0.165

W(D)=0.165

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 9.6*(1-0.35)

= 6.24

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=6.24*0.165+16.3*0.835

WACC =14.64%