Question

TVA currently has a debt-equity ratio of 0.2 and an average tax rate of 34%. Using the CAPM, the firm estimates that its current equity ß is 1 and its current debt ß is 0.2857. The risk-free rate is 2% and the expected equity market risk premium (MRP) is 7%.

The firm is considering a new capital structure with a debt-equity ratio of 0.9. Any proceeds from issuing new debt will be used to repurchase shares. An investment bank has estimated that the yield to maturity on the company's bonds would rise to 6%.

What is TVA's current WACC?

What would have been the return on equity if TVA had not had any debt?

What will be the new WACC after the recapitalization?

Answer 1

cost of debt=risk free rate+beta*market risk premium=2%+0.2857*7%

cost of equity=risk free rate+beta*market risk premium=2%+1*7%=9.000%

What is TVA's current WACC?
=D/E*1/(1+D/E)*cost of debt*(1-tax rate)+1/(1+D/E)*cost of equity
=0.2/1.2*(4.000%)*(1-34%)+1/1.2*(9.000%)
=7.940%

What would have been the return on equity if TVA had not had any debt?
=(levered cost of equity+cost of debt*D/E*(1-tax rate))/(1+D/E*(1-tax rate))
=(9.000%+(4.000%)*0.2*(1-34%))/(1+0.2*(1-34%))
=8.417%

What will be the new WACC after the recapitalization?
=0.9/1.9*6%*(1-34%)+1/1.9*(8.417%+(8.417%-6%)*0.9*(1-34%))
=7.061%