Bruce & Co. expects its EBIT to be $165,000 every year forever. The company currently has no debt but can borrow at 8.6 percent while its cost of equity is 14.7 percent. The tax rate is 21 percent. The company is planning to borrow $55,000 and use the loan proceeds to repurchase shares. What will be the WACC after recapitalization?
A) 14.57 percent
B) 15.07 percent
C) 14.51 percent
D) 14.11 percent
E) 14.58 percent

Question

Quizplus · Accepted Answer

Before recapitalization:
Cost of equity = 14.7%
Cost of debt = 8.6%
Tax rate = 21%

Weight of equity = (100%)
Weight of debt = (0%)

WACC = (0.100)*(14.7%) = 14.7%

After recapitalization:
Bruce & Co. will borrow $55,000 at 8.6% and repurchase shares. This will increase the weight of debt in the capital structure.

The market value of equity will decrease by $55,000, which will lead to a decrease in the weight of equity in the capital structure.

As we don't know the new market value of the equity after repurchase, we can assume that the shares are repurchased at their current market value, which will reduce the number of outstanding shares.

Let's assume that after repurchase, the market value of the equity is $245,000.

Weight of equity = ($245,000)/($245,000 + $55,000) = 0.817

Weight of debt = ($55,000)/($245,000 + $55,000) = 0.183

The cost of equity remains the same, but the cost of debt will change due to the tax shield.

After-tax cost of debt = 8.6%*(1-21%) = 6.794%

WACC = (0.817)*(14.7%) + (0.183)*(6.794%) = 14.51%

Therefore, the new WACC after recapitalization will be 14.51%, and the correct answer is C.