Question

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of perpetual debt outstanding carrying a coupon rate of 6%. Its earnings before interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC's current cost of equity is 8.8%, and its tax rate is 40%. The firm has 10,000 shares of common stock outstanding selling at a price per share of $60.00 The firm is considering moving to a capital structure that is comprised of 40% debt and 60% equity, based on market values. The new funds would be used to replace the old debt and to repurchase stock. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on debt to rise to 7%, while the required rate of return on equity would rise to 9.5%. If this plan were carried out, what would be AJC's new WACC and total value

Answer 1

Answer:

Old WACC    7.50%

New WACC  7.38%

Explanation:

D  200,000

E  600,000 (10,000 sahres x $60)

V  800,000

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.08800

Equity weight 0.75

Kd 0.06

Debt Weight 0.25

t 0.4

$WACC = 0.088(0.75) + 0.06(1-0.4)(0.25)$

WACC 7.50000%

New WACC:

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$

Ke 0.09500

Equity weight 0.6

Kd 0.07

Debt Weight 0.4

t 0.4

$WACC = 0.095(0.6) + 0.07(1-0.4)(0.4)$

WACC 7.38000%