Question

Question 1 - (The next 2 questions are independent of each other)

a)         Trump Limited operates out of Miami Florida USA. Trump’s current earnings before interest and tax are $950,000. He projects that there will be no growth in earnings for the foreseeable   future. Trump currently has no debt, but if he choose to borrow his cost of borrowing is   seven percent. His unlevered cost is 11 percent, while his tax rate is 20 percent.

Trump is seeking to add leverage to his company and consequently borrowed $350,000 from Biden Banking Group.

What will be Trump’s WACC be after recapitalization? Kindly show all workings.

Answer 1

Solution:

Calculation of WACC of Trump

Unlevered cost of capital=Cost of equity

Cost of equity=11%

Market value of unlevered firm=Market value of equity

Market value of equity=EBIT(1-tax rate)/Unlevered cost of capital

=$950,000(1-0.20)/0.11

=$6,909,090.91

Market value debt=$350,000

Total value of capital=Market value of equity+Market value debt

=$6,909,090.91+$350,000=$7,259,090.91

After tax cost of debt=7%(1-0.20)=5.6%

WACC=Cost of equity*weight of equity+After tax cost of debt*weight of debt

=(11%*$6,909,090.91/$7,259,090.91)+5.6%*$350,000/$7,259,090.91

=10.74%