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WACC before and after issue of debt

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XYZ limited has a capital structure of 100 % ordinary equity with 6,000,000 shares outstanding at current market price of \$ 4.00. Its EBIT was \$ 4,200,000. The company pays tax at 30%.
Q 1. What is the current cost of equity in XYZ limited
Q 2. What is the WACC

Now suppose that the company sells \$ 1,000,000 of long term debt with interest rate of 10%. the debt is used for repurchase of shares. the market price of shares following the retirement is expected to increase by \$ 0.05217 per share.

Q 3.What is the market value of the company after it issues the debt.
Q 4 What is the market value of the company's equity after it issues the debt.
Q.5. What is the cost of equity after it issues the debt.
Q.6 What is the new WACC
Q.7 Explain what happened to WACC and why??

Solution Preview

XYZ limited has a capital structure of 100 % ordinary equity with 6,000,000 shares outstanding at current market price of \$ 4.00. Its EBIT was \$ 4,200,000. The company pays tax at 30%.

Q 1. What is the current cost of equity in XYZ limited

EBIT= \$4,200,000
Interest= 0
Earnings before taxes= \$4,200,000
Tax @ 30% = \$1,260,000
Profit after taxes= \$2,940,000

Number of shares= 6,000,000
Therefore, earning per share= \$0.49 =2940000/6000000
Current share price= \$4.00

Therefore, current cost of equity= 12.25% =0.49/4

Answer: current cost of equity= 12.25%

Q 2. What is the WACC

Since there is no debt, WACC = Cost of equity= 12.25%