Question

Chiquitica Company currently does not use any debt at all? (it is an? all-equity firm). The firm has three million shares selling for ?$37 per share. Its beta is 1.2, and the current? risk-free rate is 2.7%. The expected return on the market for the coming year is 10.5%. Chiquitica Company will sell ?$37,000,000 in corporate bonds with a???$1,000 par value and use the proceeds to retire stock. The bonds have a yield to maturity of 12?%. When the bonds are? sold, the beta of the company will increase to 1.5. What was the WACC of Chiquitica Company before the bond? sale? What is the adjusted WACC of Chiquitica Company after the bond sale if the corporate tax rate is 20?%? ?Hint: Start with the capital structure of an? all-equity firm and then figure out how it changes with the bond sale and how the procees from that sale are used.

Please show ALL work, not excel unless clearly states the steps.

Answer 1

Currently, firm has 3,000,000 shares with $37 per share value. Current total value of equity = $111 mil

Cost of Equity (by CAMP method) = Rf + B (Rm – Rf)

where,

Rf is Risk Free Rate = 2.7%

B is Beta = 1.2

Rm is Market Return (Expected) = 10.5%

Hence, Cost of Equity = 2.7% + 1.2 * (10.5% - 2.7%) = 12.06%

Since, it is an all equity firm, WACC = Cost of Equity = 12.06%

Now, company plans to raise $37 mil by bonds. This would be used to retire $37 mil of share. Now, debt = $37 mil (33.33%), equity = $74 mil (67.67%).

Beta has now changes to 1.5

New Cost of Equity = 2.7% + 1.5 * (10.5% - 2.7%) = 14.4%

Cost of Debt (post tax) = YTM * (1 – tax rate) = 12% * (1 – 20%) = 9.6%.

WACC = (33.33% * 9.6%) + (67.67% * 14.4%) = 12.8%