Question

ExxonMobil has historically had a very low debt-to-equity ratio within the oil industry, but it recently issued $12 billion in new debt to raise capital to buy up distressed rivals. The cost of this debt turns out to have been around 2%. In this problem we'll calculate how this bond issuance may have affected ExxonMobil's cost of capital.

For the sake of this problem, assume that ExxonMobil was an unlevered firm prior to this debt issuance (at the time of the above mentioned debt issuance the debt-to-equity ratio of ExxonMobil was just over 0.1, so ExxonMobil was pretty unlevered at the time). The equity beta of ExxonMobil is 0.85, the risk-free rate of return is 0.5% and the market risk premium is 4%. The EBIT for ExxonMobil is $15 billion, which you can assume will remain constant in perpetuity. The tax rate is 35%, and earnings after taxes are paid out entirely as dividends.

Your task in this problem is to calculate the WACC for ExxonMobil before and after the bond issuance.

Answer 1

before 3.90%

after 3.64%

Step-by-step explanation:

Using CAPM we solve for cost of equity:

`Ke= r_f + \beta (r_m-r_f)`

risk free = 0.005

premium market = (market rate - risk free) 0.04

beta(non diversifiable risk) = 0.85

`Ke= 0.005 + 0.85 (0.04)`

Ke 0.03900

As the firm was unlevered (no debt) their cost of captial is the cost of their equity. 3.90%

Now, we have to consider the debt and the tax shield debt provides so we use the complete WACC formula:

`WACC = K_e((E)/(E+D)) + K_d(1-t)((D)/(E+D))`

Ke 0.03900

Equity weight 0.9

Kd 0.02

Debt Weight 0.1

t 0.35

`WACC = 0.039(0.9) + 0.02(1-0.35)(0.1)`

WACC 3.64000%

Answer 2

The WACC before bond issuance is 3.9% and the WACC after bond issuance is 3.71%

Step-by-step explanation:

In order to calculate the WACC before bond issuance , we would have to calculate first the cost of equity using capital asset pricing model .

So Using CAPM we have Rf + Beta x Market risk premium

= 0.5% + 0.85 * 4%

= 3.9% . cost of equity

Therefore WACC before bond issuance = (Cost of equity x weight of equity + cost of debt (1-tax) x weight of debt)

= 3.9% . WACC before bond issuance will be equal to cost of equity in this case as there is no debt issue.

In order to calculate the WACC after bond issuance we make the following calculation:

WACC after bond issuance = (Cost of equity x weight of equity + cost of debt (1-tax) x weight of debt)

= (3.9% x 0.9) + (2% x 0.1)

= 3.51% + 0.2%

= 3.71%