The firm is considering moving to a capital structure that is comprised of 40 percent debt and 60 percent 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 riskiness resulting from the leverage increase would cause the required rate of return on debt to rise to 7 percent, while the required rate of return on equity would increase to 9.5 percent. If this plan were carried out, what would be AJC's new WACC and total value?
A) 7.38%; $800,008
B) 7.38%; $813,008
C) 7.50%; $813,008
D) 7.50%; $790,008
E) 7.80%; $790,008

Question

Quizplus · Accepted Answer

To calculate the new WACC, we need to first calculate the after-tax cost of debt and the cost of equity:

After-tax cost of debt = 7% x (1 - 0.35) = 4.55%
Cost of equity = 9.5%

Next, we can use the WACC formula to calculate the new WACC:

WACC = (E/V) x Cost of equity + (D/V) x After-tax cost of debt x (1 - Corporate tax rate)

E/V = 60%
D/V = 40%
Corporate tax rate = 35%

WACC = (0.6 x 9.5%) + (0.4 x 4.55% x (1 - 0.35)) = 7.38%

Finally, we can use the WACC formula to calculate the total value of the firm:

Total value = E + D

E = current stock price x number of shares outstanding = $1.6 million
D = current debt = $0.8 million

Total value = $1.6 million + $0.8 million = $2.4 million

Therefore, the new WACC is 7.38% and the total value of the firm is $813,008. The answer is B.

The Firm Is Considering Moving to a Capital Structure That