Question

Due to mismanagement, Pakistan Steel Mills is currently over levered with a debt to capital ratio of 80% and a pre-tax cost of debt of 8%. Management of Pakistan Steel Mills is considering a restructuring that will reduce the company's debt to capital ratio to 40% and its pre-tax cost of debt to 6%.
Current:
Debt/(Debt+Equity) = 80%
Cost of Debt (pre-tax) = 8%
Cost of Equity = 24.10%

Recapitalised:
Debt/(Debt+Equity) = 40%
Cost of Debt (pre-tax) = 6%
Cost of Equity = ?

If the marginal tax rate is 25%, the risk-free rate is 2.5%, and the equity risk premium is 6%, estimate the cost of capital after the restructuring.

Answer 1

The estimated cost of capital after the restructuring is 10.82%.

Using the MM Proposition II with taxes, we need to first calculate the Cost of unlevered equity;

Cost of unlevered equity = (Cost of levered equity+cost of debt*D/E*(1-tax rate))/(1+D/E*(1-tax rate))

Cost of unlevered equity = (24.10% + 8%*80%/20%*(1-25%)) / (1+80%/20%*(1-25%))

Cost of unlevered equity = 12.03

Cost of levered equity = Cost of unlevered equity + (Cost of unlevered equity-Cost of debt)*D/E*(1-tax rate)

Cost of levered equity = 12.03% + (12.0250%-6%)*40%/60%*(1-25%)

Cost of levered equity = 15.04%

Cost of capital (WACC) =40%*6%*(1-25%)+60%*15.0375%

Cost of capital (WACC) = 0.018 + 0.090225

Cost of capital (WACC) = 0.108225

Cost of capital (WACC) = 10.82%

In conclusion, the estimated cost of capital after the restructuring is 10.82%.

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