Pensacola Soda Inc.is all equity financed and generates perpetual annual EBIT of $300.Assume that the EBIT,and all other cash flows,occur at year end and that we are currently at the beginning of a year.Assume that Pensacola has a 100% payout rate,1,500 shares outstanding,and that shareholders require a return of 5%.Assume that the tax rate is 0%.
Pensacola is considering an open market stock repurchase.It plans to buy 20% of its outstanding shares at the price of $4.00 per share.The repurchased shares will be cancelled.It will finance the repurchase by issuing perpetual bonds worth a total sum of $1,200 and a coupon rate (and yield)of 3%.Assume that the tax rate is 0%.
If Pensacola goes ahead with the repurchase,then what is its WACC after the repurchase is complete?

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Quizplus · Accepted Answer

First, we need to find the return required by shareholders in the levered firm, which is found using M&M Proposition II: k_E = k_U + (k_U - k_D) 11ea7fdb_fc62_7e7e_a768_1d1dd422a614_TB2902_11 Since V_L = E + D E = V_L - D According to M&M Proposition I, the value of the levered firm is equal to the unlevered firm. V_L = V_U = 11ea7fdb_fc62_7e7f_a768_296d429de935_TB2902_11 = $6,000 E = $6,000 - $1,200 = $4,800 k_E = 0.05 + (0.05 - 0.03) 11ea7fdb_fc62_7e80_a768_7563153017dd_TB2902_11 = 0.055 or 5.5% Now, using the information above, calculate WACC. WACC = 11ea7fdb_fc62_7e81_a768_a92658c04433_TB2902_11 k_E + 11ea7fdb_fc62_7e82_a768_b54d5c5e3ea6_TB2902_11 k_D WACC = 11ea7fdb_fc62_a593_a768_a540f8c053f4_TB2902_11 (5.5%) + 11ea7fdb_fc62_a594_a768_a955dd8caba2_TB2902_11 (3%) WACC = 5% With no taxes, the WACC is constant across all capital structures and is equal to k_U or 5%