Question

An unlevered company (just common stock, no preferred) with a cost of equity of 12% generates $5 million in earnings before interest and taxes (EBIT) each year. The decides to alter its capital structure to include debt by adding $6 million in debt with a pre-tax cost of 6% to its capital structure and using the proceeds to reduce equity by a like amount as to keep total invested capital unchanged. The firm pays a tax rate of 29%.

Assuming that the company's EBIT stream can be earned into perpetuity and that the debt can be perpetually issued (or rolled), what is the firm's new weighted average cost of capital?

Answer 1

Value of Unlevered Firm = EBIT (1-taxes) / Ke

Ke = Unlevered Cost of Equity

= 5(1-0.29) / 0.12

= 29.58

Value of Levered Firm =  Value of Unlevered Firm + taxes * Debt added

= 29.58+ 0.29 * 6

= 31.32

Equity Value = Value of Levered Firm - Debt

= 31.32 - 6

= 25.32

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

= 12% * 25.32/ 31.32+ 6% (1-0.29) * 6 / 31.32

= 9.78%

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