Question

Omega Corporation has 10 million shares outstanding, now trading at $55 per share. The firm has estimatedthe expected rate of return to shareholders at about 12%. It has also issued long-term bonds at an interestrate of 7% and has a debt value of $200 million. It pays tax at a marginal rate of 21%.

How much higher would WACC be if Omega used no debt at all?

Answer 1

WACC without debt is higher by = 1.7%

Step-by-step explanation:

The weighted Average cost of Capital (WACC) is the average cost of capital for the different sources of long-term capital available to a firm weighted according to the proportion each source of finance bears to the total capital in the pool..

To determine the amount by which WACC would be higher, is the difference between WACC with and without debt.

WACC using debt

Step 1

Cost of debt = Before tax cost of debt × (1-T)

= 7%× (1-0.21) = 5.5%

Step 2

Market value of debt and equity

Market of debt = 200 million

Market value of equity = $55 × 10 = $550 million

Total market value = 550 + 200 = $750 million

Step 3

WACC with debt = ((5.5%× 200) + (12%.× 550))/ 750

= 10.3%

WACC without debt (i.e only equity)

WACC without debt = cost of equity = 12%

Difference in WACC between with and without debt

= 12%- 10.3%

= 1.7%

The WACC without debt is higher by 1.7%