Question

You would like to estimate the WACC 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, with 25% debt financing at a cost of 6% and a corporate tax rate of 40%, is estimated to be 7.65%.

Step-by-step explanation:

To estimate the weighted average cost of capital (WACC) for a new airline business with an unlevered cost of capital at 9%, 25% debt financing at a 6% cost, and a corporate tax rate of 40%, we use the WACC formula:

WACC = E/V * Re + D/V * Rd * (1 - Tc)

Where:

• E = market value of the equity
• V = E + D = total market value of the firm's financing (equity + debt)
• Re = cost of equity
• D = market value of the firm's debt
• Rd = cost of debt
• Tc = corporate tax rate

In this scenario, the firm is not 100% equity financed, so the Re (cost of equity) is the unlevered cost of capital, which is 9%. The proportions of debt (D/V) and equity (E/V) are 0.25 and 0.75, respectively, given that the business is 25% debt-financed.

Therefore, we can calculate:

WACC = 0.75 * 9% + 0.25 * 6% * (1 - 0.40)

The WACC for the new airline business would thus be:

WACC = 6.75% + 1.5% * 0.60

WACC = 6.75% + 0.9%

WACC = 7.65%

The estimated WACC for the new airline business is 7.65%.