Here is Establishment Industries� market-value balance sheet (figures in millions):
| Net working capital | $ | 700 | Debt | $ | 1080 |
| Long-term assets | 2600 | Equity | 2220 | ||
| Value of firm | $ | 3300 | $ | 3300 | |
| The debt is yielding 0.64%, and the cost of equity is 14.6%. The tax rate is 32%. Investors expect this level of debt to be permanent. |
| a. | What is Establishment�s WACC? (Do not round intermediate calculations. Round your answer to 2 decimal places.) |
| b. | How would the market-value balance sheet change if Establishment retired all its debt. (Leave no cells blank – be certain to enter “0” wherever required.) |
Answer:
A = Establishment WACC =11.21%
B
How would the market-value balance sheet change if Establishment retired all its debt?
Answer:
New Market-Value Balance Sheet(figures in millions)
| Net working capital | 700 | Debt | 0 |
| 0Long-term assets | 2254.4 | Equity | 2945.4 |
| Value of firm | 2954.4 | Total | 2945.4 |
Working notes for the above answer is as under
a.
WACC
=wDebt×rDebt×(1 –Tc) +wEquity×rEquity
= ($1,080 / $3,300)×.064×(1 – .32) + ($2,220 / $3,300)×.146
= .1121,
or 11.21%
b.
If the firm retired all of its debt, its market value would decrease by the present value of the tax shield on the retired debt.
Reduction in firm value
= .32×$1,080
= $345.6
Total debt and equity
= $3,300 – 345.6
= $2954.4
If debt is zero, then equity
= $2954.4
The reduction in the firm’s value will also affect the value of its long-term assets, so:Long-term assets
= $2,600 – 345.6
= $2,254.4
Net working capital will remain unchanged at $700
