Johnson’s Popcorn Enterprises is unlevered and is valued at $835,000. Johnson’s
ID: 1174989 • Letter: J
Question
Johnson’s Popcorn Enterprises is unlevered and is valued at $835,000. Johnson’s has decided that including debt in its capital structure would increase its value. Prior to including debt, the cost of equity is 7.5%.
Johnson’s has determined that issuing $235,000 of new debt at a 4.2% interest rate would be optimal. Johnson’s would repurchase $235,000 of stock with the proceeds from the debt issue. Johnson’s has a marginal tax rate of 38%. What will Johnson’s new WACC be? Assume the attributes of MM Proposition II (with taxes) are at play.
Explanation / Answer
Value of levered firm=value of unlevered firm+debt*tax rate=835000+235000*38%
cost of levered equity according to MM2 Proposition=7.5%+(7.5%-4.2%)*(235000/(924300-235000))*(1-38%)=8.1975%
WACC=8.1975%*(924300-235000)/924300+4.2%*235000*(1-38%)/924300=6.7754%
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