BM Corporation has a debt-to-equity ratio of 1:4,a WACC of 16% and a corporate tax rate of 30%.In a financial restructuring designed to raise the proportion of the firm financed with debt to 40%,it issues debt and buys back its equity with the proceeds.Find the firm's new WACC given the assumptions of the Hamada model.

Question

Quizplus · Accepted Answer

The Hamada equation adjusts the unlevered cost of capital to account for the tax shield of debt and the increased risk from leverage. The original debt-to-equity ratio is 1:4 (or 0.25), and the target is to increase the debt proportion to 40%, which means a debt-to-equity ratio of 2:3 (or 0.6667). Using the formula for the levered cost of capital under the Hamada model: $WACC_{L} = WACC_{U} + (WACC_{U} - i)(1 - T)(D/E)$, where $WACC_{U}$ is the unlevered cost of capital (which we can assume is the original WACC of 16%), $i$ is the cost of debt (which is not given, so we cannot calculate directly but can assume it remains constant for the purpose of this explanation), $T$ is the tax rate (30%), and $D/E$ is the new debt-to-equity ratio (0.6667). Without the cost of debt explicitly given, we focus on the effect of increasing leverage according to the Hamada model, which suggests that as leverage increases, the WACC decreases due to the tax shield of debt, assuming the cost of debt is less than the original WACC. Therefore, the correct answer is the one showing a decrease in WACC, which is 14.98%.

BM Corporation Has a Debt-To-Equity Ratio of 1:4,a WACC of 16