Question

You would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 9%. However, the new business will be 25% debt financed, and you anticipate its debt cost of capital will be 6%. If its corporate tax rate is 40%, what is your estimate of its WACC?

Answer 1

The weighted average cost of capital (WACC) for the new airline business, which is 25% debt financed and has an after-tax cost of debt of 6% and an unlevered cost of capital of 9%, is estimated to be 7.65%.

Step-by-step explanation:

To estimate the weighted average cost of capital (WACC) for a new airline business, we first need to take into account the proportion of debt and equity in the company's capital structure. Given that the business will be 25% debt financed and the cost of debt is 6%, we can calculate the after-tax cost of debt since interest is tax-deductible. The corporate tax rate is 40%, reducing the cost of debt to 3.6% (which is 6% * (1 - 0.4)).

The remaining 75% of the financing will come from equity, with an unlevered cost of capital of 9%. Therefore, we can compute WACC using the formula: WACC = E/V * Re + D/V * Rd * (1 - Tc), where E is the market value of equity, D is the market value of debt, V is the total value of financing (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate.

The calculation would be: WACC = 0.75 * 9% + 0.25 * 6% * (1 - 0.4) = 6.75% + 0.9% = 7.65%.

Answer 2

7.65%

Step-by-step explanation:

WACC = wE*rE + wD*rd(1-tax)

wE= weight of equity = (100% - 25%) = 75%

rE = cost of equity = 9% or 0.09

wD = weight of debt = 25% or 0.25

rd = pretax cost of debt = 6% or 0.06

tax = 40%

WACC = (0.75 *0.09) + [0.25 *0.06(1-0.40) ]

WACC = 0.0675 + 0.009

WACC = 0.0765 or 7.65%