Question

Q Ltd, an airplane parts manufacturer, currently has $25 million in outstanding debt and has 10 million shares outstanding. The market value per share is $25. The company is currently rated A, its bonds have a yield to maturity of 10%, and the current beta of the stock is 1.06. The risk-free rate is 8% now, and the company’s tax is 40%. The risk premium for the equity is 5.5%. (a) What is the company’s current weighted average cost of capital? (b) The company is considering a repurchase of 4 million shares at $25 per share with new debt. It is estimated that this will push the company’s rating down to a B (with a new yield to maturity of 13% for the firm’s debt ). What will the company’s beta and WACC be after the stock repurchase?

Answer 1

Answer :

(a) Calculation of company's current WACC :

Cost of equity = Rf + b(risk premium)

= 8% + 1.06(5.5%)

= 13.83%

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

= 10% ( 1 - 40%)

= 6%

WACC = cost of equity * equity value / total capital + cost of debt * debt value / total capital

= 13.83% * 250 / 275 + 6% * 25 / 275

= 12.57 + 0.55

= 13.12%

(b) new equity = 250 - (4*25)

= 250 - 100

= 150

New debt = 25 + 100

= 125

company beta after stock repurchase :

Asset beta = Equity beta / [ 1+ (1- tax rate) * debt/equity ]

= 1.06 / [ 1 + ( 1 -40%) * 125 /150 ]

= 1.06 / [ 1 + 0.5]

= 0.71

Company's beta after stock repurchase = 0.71

New after tax cost of debt = 13 * (1-40%)

= 7.80%

WACC = 13.83% * 150/275 + 7.8% * 125/275

= 7.54% + 3.55%

= 11.09%