Question

Bruce & Co. expects its EBIT to be $100,000 every year forever. The firm can borrow at 11%. They currently have no debt, a cost of equity of 18%, and a 20% tax rate. Bruce will borrow $61,000 and use the proceeds to repurchase shares. What will the WACC be after recapitalization? [Note: Round to 2 decimal places]

Please explain each step when solving.

Answer 1

As it is all-equity financed, WACC will be cost of equity before recapitalization

Value of the firm now=EBIT*(1-tax rate)/cost of equity=100000*(1-20%)/18%=444444.4444

We know that

Value of levered firm=value of unlevered firm+debt*tax rate=444444.4444+20%*61000=456644.4444

So, Debt=61000

Equity=456644.4444-61000=395644.4444

Cost of equity=18%+61000/395644.4444*(18%-11%)=19.0792519%

WACC after recapitalization=61000/456644.4444*11%*(1-20%)+395644.4444/456644.4444*19.0792519%=17.7061171%