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Finance 8172765

Pennington Airlines is considering changing its capital structure by increasing debt by $2 million and repurchasing $2 million of equity. This will result in $5 million of debt and $5 million of equity. The company estimates its new bonds will have a yield of 8.5%. To calculate the estimated WACC, the assistant first calculates Pennington's unlevered beta and relevered beta given the new capital structure. Then, the cost of equity is calculated using the CAPM model. Finally, the WACC is calculated as a weighted average of the after-tax cost of debt and cost of equity. The estimated WACC for Pennington's new capital structure is 10.90%.

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Md Miraz
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1K views

Finance 8172765

Pennington Airlines is considering changing its capital structure by increasing debt by $2 million and repurchasing $2 million of equity. This will result in $5 million of debt and $5 million of equity. The company estimates its new bonds will have a yield of 8.5%. To calculate the estimated WACC, the assistant first calculates Pennington's unlevered beta and relevered beta given the new capital structure. Then, the cost of equity is calculated using the CAPM model. Finally, the WACC is calculated as a weighted average of the after-tax cost of debt and cost of equity. The estimated WACC for Pennington's new capital structure is 10.90%.

Uploaded by

Md Miraz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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Question:

Pennington Airlines currently has a beta of 1.2. The companys capital


structure consists of $7 million of equity and $3 million of debt. The
company is considering changing its capital structure by increasing its
debt by $2 million and repurchasing common stock. After the plan is
completed, the company will have $5 million of debt and $5 million of
equity. The company estimates that if it goes ahead with the plan, its
bonds will have a nominal YTM of 8.5%. The companys tax rate is 40%.
The risk-free rate is 6% and the market risk premium is 7%. What is the
companys estimated WACC if it recapitalizes?
Solution: Computation of Weighted Average cost of capital
In this case we first calculate beta with no debt and the new cost of capital with the
new capital structure before you can calculate the firms Weighted Average Cost of
Capital.
Step 1:
equation:

Calculate the firms unlevered beta using the Hamada

bL

= bU[1 + (1 - T)(D/E)]

1.2

= bU[1 + (0.6)($3/$7)]

1.2

= 1.2571bU

bU

= 0.954545.

Step 2:

Calculate the firms new beta with the new capital structure:

bL = bU[1 + (1 - T)(D/E)]
bL = 0.954545[1 + (0.6)($5/$5)]
bL = 1.5273.
Step 3:
Calculate the firms new cost of equity with the new capital
structure:
ks = kRF + (RP)b
ks = 6% + 7%(1.5273)
ks = 16.6909%.
Step 4:

Calculate the firms new WACC:

WACC = wdkd(1 - T) + wcks

WACC = 0.5(8.5%)(0.6) + 0.5(16.6909%)


WACC = 10.8955% or 10.90%.
Hence the Weighted Average Cost of Capital is 10.90%

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