Question

Adjusted WACC. Ashman Motors is currently an​ all-equity firm. It has two million shares​ outstanding, selling for $42 per share. The company has a beta of 1.4, with the current​ risk-free rate at 5.1% and the market premium at 8.7% the tax rate is 15​% for the company. Ashman has decided to sell $42 million of bonds and retire half its stock. The bonds will have a yield to maturity of 8.7​%. The beta of the company will rise to 1.9 with the new debt. What was​ Ashman's adjusted WACC before selling the​ bonds? What is its new WACC after selling the bonds and retiring the stock with the proceeds from the sale of the​ bonds?

Hint​: The weight of equity before selling the bond is​ 100%.

Answer 1

Ashman Motors' pre-adjusted WACC was calculated as the cost of equity using the CAPM formula, considering it was initially an all-equity firm. After issuing bonds and retiring stocks, the new WACC is computed by considering the weights of equity and debt in the new capital structure and their corresponding costs, as well as the tax benefits of debt.

Step-by-step explanation:

The Weighted Average Cost of Capital (WACC) is a financial metric used to measure the average rate of return required by all of a company's security holders. Before Ashman Motors sold its bonds, as an all-equity firm, its WACC can be calculated using the Capital Asset Pricing Model (CAPM) formula for the cost of equity:

Cost of Equity = Risk-free Rate + Beta * (Market Premium)

Pre-adjusted WACC = Cost of Equity, since the firm is all equity at this point and the weight of equity is 100%.

To find the new WACC after the sale of bonds and retirement of stock, we must calculate the after-tax cost of debt, re-weigh the cost of equity and cost of debt based on the new capital structure, and consider the new beta which reflects increased risk due to higher leverage.

New WACC = (E/V) * Cost of Equity + (D/V) * Cost of Debt * (1 - Tax Rate)

Where:

• E = Market Value of Equity
• D = Market Value of Debt
• V = Total Value (E + D)
• Cost of Debt = Yield to maturity on the new bonds

Applying the CAPM formula with the new beta gives the new cost of equity. The new weights (E/V and D/V) consider that the firm retired half its stock with proceeds from the bond sale. Finally, the tax shield effect of the debt is accounted for by multiplying the cost of debt with (1 - Tax Rate).