Question

Slecat Corp. is in the 40% tax bracket and has a capital structure that is composed entirely of equity. They are considering altering its capital structure to take advantage of prevailing interest rates. After consulting with several investment bankers, they obtain a before-tax cost of debt estimate of 8% if they recapitalize to 40% debt and 60% equity. The firm will use the proceeds from the debt issuance to repurchase shares of common stock.

The corporation's existing stock has a beta of 1.6 on 20 million shares outstanding. Investors can earn a 4% rate of return on risk-free assets and a 14% rate of return on the market.

Slecat's expected free cash flows next year are $80 million. These cash flows are expected to grow at a rate of 5% for the forseeable future. The company currently has no short-term investments nor preferred stock outstanding.

What is Slecat's WACC after the recapitalization? (Hint: first find the firm's levered beta.)

		16.3%
		17.8%
		20.0%
		21.5%

Please show work

Answer 1

Recapitalize Debt and Equity weights:

Debt weight = 40%

Equity Weights = 60%

- Stock's existing all equity Beta = 1.60

Calculating the unlevered beta of stock;-

Levered Beta = Unlevered Beta*[1+(1-Tax rate)*D/E]

= 1.60*[1+(1-0.40)*(0.40/0.60)]

= 2.24

So, levered Beat = 2.24

As per CAPM,

Rf = Risk free Return = 4%

Rm = Market return = 14%

Expected Return = 4% + 2.24(14% - 4%)

= 26.40%

- Before tax cost of debt = 8%

Computing WACC:-

WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

WACC = (0.40)(8%)(1-0.40) + (0.60)(26.40%)

WACC = 1.92% + 15.84%

WACC = 17.76%

So, WACC is 17.8%. Hence Option B

Note- As question has only asked to compute WACC, WACC is been computed.

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