36. Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and

Question

36. Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt and moving to the new debt/assets ratio indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, that is, what is WACCOld - WACCNew?

New Debt/Assets 55% Original cost of equity, rs 10.0%
New Equity/Assets 45% New cost of equity = rs 11.0%
Interest rate new = rd 7.0% Tax rate 40%

a. 2.74%
b. 3.01%
c. 3.32%
d. 3.65%
e. 4.01%

Explanation / Answer

The company is an all equity firm when the company has zero debt. Therefore, the weight of equity = 100% or 1.00 Cost of equity = 10.% WACC = Weight of equity * Cost of equity              = 1.00 * 0.10              = 0.10 or 10% When the company is an all equity firm, the value of WACC is equal to the cost of equity Computing the WACC after raising the new debt. WACC = Weight of debt * Cost of debt * ( 1 - Tax rate) + Weight of equity * Cost of equity              = 0.55 * 0.07 * (1 - 0.4) + 0.45 * 0.11              = 0.0231 + 0.0495             = 0.0726 or 7.26% Difference in WACC is WACC old - WACC new = 0.10 - 0.0726                                          = 0.0274 or 2.74% Therefore, the correct option is a) 2.74%

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