Question

Ashman Motors is currently an​ all-equity firm. It has two million shares​ outstanding, selling for ​$43 per share. The company has a beta of 1.5​, with the current​ risk-free rate at 4.7​% and the market premium at 7.7​%. The tax rate is 15​% for the company. Ashman has decided to sell ​$43 million of bonds and retire half its stock. The bonds will have a yield to maturity of 10.8​%. The beta of the company will rise to 1.9 with the new debt.

What was​ Ashman's adjusted WACC before selling the​ bonds?

What is its new WACC after selling the bonds and retiring the stock with the proceeds from the sale of the​ bonds?  

Hint​: The weight of equity before selling the bond is​ 100%.

Answer 1

1

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 4.7 + 1.5 * (7.7)

Expected return% = 16.25

2

Weight of equity = 1-D/A

Weight of equity = 1-0.5

W(E)=0.5

Weight of debt = D/A

Weight of debt = 0.5

W(D)=0.5

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 4.7 + 1.9 * (7.7 - 4.7)

Cost of equity% = 10.4

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

After tax cost of debt = 10.8*(1-0.15)

= 9.18

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

WACC=9.18*0.5+10.4*0.5

WACC =9.79%