Gator Fabrics Inc. currently has zero debt (i.e., mc019-1.jpg = 0). It is a zero

Question

Gator Fabrics Inc. currently has zero debt (i.e., mc019-1.jpg = 0). It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOLD - WACCNEW

wd 70% Orig cost of equity, rs 10.0%

wc 30% New cost of equity = rs 11.0%

Interest rate new = rd 5.0% Tax rate 40%

a. 5.20%

b. 3.54%

c. 4.60%

d. 4.23%

e. 4.05%

Explanation / Answer

Correct option is > c. 4.60%

WACC old = Cost of old equity = 10%

Cost of new equity will be considered for calculating the new WACC as due to increased leverage:

WACC new = Cost of new equity x Weight of equity + Cost of debt x Weight of debt x (1-Tax rate)

WACC new = 11% x 30% + 5% x 70% x (1-40%)

WACC new = 5.40%

----

Change in WACC = WACC old - WACC new

Change in WACC = 10% -5.40%

Change in WACC = 4.60%

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