Question

Angel's Bangles, a sweatshop specializing in Excel programming and jewelery manufacturing, is considering a recapitalization. It currently has 60.0% debt yielding 9.0%. It's stock is risky because of all of that debt, with a beta of 1.8. It's tax rate is 40%. Angel's would like to reduce its debt down to 20.0% of its capital structure and figures it can reduce its cost of debt to 7.0% with this change. The risk free rate is 4.0% and the market risk premium is 6.0%. What will be Angel's WACC after the recapitalization? Hint: Hamada's formula will be useful.      

Answer 1

old debt to equity = 0.6/0.4 = 1.5

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

1.8 = Unlevered Beta*(1+((1-0.4)*(1.5)))

Unlevered Beta = 0.95

new debt to equity = 0.2/0.8=0.25

Levered Beta = Unlevered Beta x (1 + ((1 – Tax Rate) x (Debt/Equity)))

levered beta = 0.95*(1+((1-0.4)*(0.25)))

levered beta = 1.09

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 4 + 1.09 * (6)

Cost of equity% = 10.54

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

After tax cost of debt = 7*(1-0.4)

= 4.2

Weight of equity = 1-D/A

Weight of equity = 1-0.2

W(E)=0.8

Weight of debt = D/A

Weight of debt = 0.2

W(D)=0.2

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

WACC=4.2*0.2+10.54*0.8

WACC% = 9.27