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Nantucket Nugget Capital Structure: Calculate New WACC

The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in their capital structure would increase their value. The current cost of equity is 12%. Under consideration is issuing $300,000 in new debt (perpetuity) with an 8% interest rate. Nantucket would repurchase $300,000 of stock with the proceeds of the debt issue. There are currently 32,000 shares outstanding and their corporate tax rate is 34%.

A. What will the corporations's new WACC be?
B. If the marginal tax bracket is zero what would the new WACC be?

Solution Preview

A. WACC = Proportion of debt X after tax cost of debt + proportion of equity X cost of equity
Due to the use of debt, the value of firm will increase by the interest tax shield. (MM Proposition II with taxes)
Interest tax shield = Value of debt X tax ...