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The Weighted Average Cost of Capital (WACC) id the minimum after tax returns that a business must earn its shareholders. WACC is calculate by determining the cost of each component of the company’s capital structure and dividing it with the weight of the component. This ratio is important in evaluating the most affordable source of financing that a business should adopt to maximize its shareholder’s wealth.
Calculation of WACC
WACC= E/(E+D+P)× re + D/(E+D+P)× (1-t)×rd + P/(E+D+P)× rp
Which is similar to:
WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)+ r(P) × w(E)
E          =          Market value of equity
D         =          Market value of debt
P          =          Market value of preferred stock
re          =          Cost of equity
rd          =          Cost of debt
rp          =          Cost of preferred stock
t           =          Marginal tax rate
1-t       =          Tax shield
 
MM Pizza
Current WACC is 8%
Market risk rm is 5%
Beta is 0.8 (Unlevered)
Cost of Equity is 8%
Cost of Debt is 4%
Risk free rate is 4%
Corporate tax is 20%
After Borrowing Cost
Weighted average cost                        Millions
Current market value of equity           1000
Current market value of debt              500
Total Market value                              1500
Weight of equity                                 66.67%
Weight of debt                                                33.33%
Cost of Equity
re= rf+ β×(rm − rf)
Where:
rf          =          Risk-free rate (represented by 10-yr U.S. Treasury bond rate)
β          =          Predicted equity beta (levered)
(rm − rf)            =          Market risk premium
Levered β= Unlevered β× [1 + [(D/E) × (1−t) + P/E]]
 
With Tax
Levered β= 4% × [1+ (500/1000)× 0.8)]
Levered β= 5.6%
Cost of equity using CAPM
Cost of Equity = Risk Free Rate + Beta × Market Risk Premium
Cost of Equity= 4+ (5.6 (5-4))= 9.6%
Weighted cost of equity= 0.667× 9.6%= 6.40%
 
No Tax
Levered β= 4% × [1+ (500/1000)× 1.0)]
Levered β= 6%
Cost of equity using CAPM
Cost of Equity = Risk Free Rate + Beta × Market Risk Premium
Cost of Equity= 4+ (6 (5-4))= 10%
Weighted cost of equity= 0.667× 10%= 6.67%
 
Weighted Cost of Debt

  1. Debt and Tax

D/(E+D+P)× (1-t)×rd
500/1500× 0.8×4%= 1.067
WACC= weight of equity + Weight of debt
WACC= 6.4+ 1.067= 7.467%
 
 

  1. No debt and tax

D/(E+D+P)× (1-t)×rd
0/1500× 0.8×4%= 0
WACC= weight of equity + Weight of debt
WACC= 6.4+ 0= 6.4%
 

  1. No debt and no tax

D/(E+D+P)× (1-t)×rd
0/1500× 1×4%= 0
WACC= weight of equity + Weight of debt
WACC= 0/1500× 1×4%= 0
 

  1. Debt and no tax

D/(E+D+P)× (1-t)×rd
500/1500× 1×4%= 1.33%
WACC= weight of equity + Weight of debt
WACC= 6.67+ 1.33= 8.0%
 
Conclusion
From the analysis, the new WACC is 7.467% where there is debt and tax, 6.4% where there is no debt but there is tax. It is 6.67% where there is no debt and no tax, and 8.0% where there is debt and no tax. Therefore, Millner should use this method to raise capital in all scenarios since they all have a WACC lesser than 8% except where there is debt and no tax, where still the WACC is 8%. In addition, the use debt enables the business to increase its capital base by 500 million without diluting shareholder’s ownership of the company.