Fawlty Brake Systems Inc.is all equity financed and generates perpetual annual EBIT of $600.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 Fawlty has a 100% payout rate,1,000 shares outstanding,and that shareholders require a return of 6%.Assume that the tax rate is 0%.
Fawlty is considering an open market stock repurchase.It plans to buy 20% of its outstanding shares at the price of $10.00 per share.The repurchased shares will be cancelled.It will finance the repurchase by issuing perpetual bonds worth a total sum of $2,000 and a coupon rate (and yield)of 4%.Assume that the tax rate is 0%.
If Fawlty 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_cca5_a768_71c8088d3b12_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_cca6_a768_e1a52d293d18_TB2902_11 = $10,000 E = $10,000 - $2,000 = $8,000 k_E = 0.06 + (0.06 - 0.04) 11ea7fdb_fc62_f3b7_a768_d9614634a3da_TB2902_11 = 0.065 or 6.5% Now, using the information above, calculate WACC. WACC = 11ea7fdb_fc62_f3b8_a768_93db29a6883b_TB2902_11 k_E + 11ea7fdb_fc62_f3b9_a768_5bb7c9e20889_TB2902_11 k_D WACC = 11ea7fdb_fc62_f3ba_a768_ff03626174ce_TB2902_11 (6.5%) + 11ea7fdb_fc62_f3bb_a768_0bb233397360_TB2902_11 (4%) WACC = 6% With no taxes, the WACC is constant across all capital structures and is equal to k_U or 6%