Your team would like to estimate the weighted average cost of capital for a new
ID: 2613881 • Letter: Y
Question
Your team would like to estimate the weighted average cost of capital for a new airline business, to be headed by Mr. Moneypockets. Based on its industry asset beta, your team has already estimated an unlevered cost of capital for the firm of 9%. However, the new airline business will be 25% debt financed, and you anticipate its debt cost of capital will be 6%. If its corporate tax rate is 40%, what is your estimate of its WACC? As you brief Mr. Moneypockets on your levered WACC, your team will explain what type of Treasury security you are using for the "risk free" rate in the CAPM to calculate the equity cost of capital inherent to the 9% unlevered cost of capital, as well as how the debt costs gets reduced by the tax "break."
Explanation / Answer
WACC = [ [Ke * We] + [Kd (1-T) * Wd ] ]
= [ [ 9% * 0.75] + [ 6% (1-0.40) * 0.25 ] ]
= 6.75% + [ 6% * 0.60 *0.25]
= 6.75% + 0.9%
= 7.65%
In case of debt after tax cost is considered as the int paid on debt allowed as tax deduction.
Pls comment, if any further assistance is requitred
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