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WACC and the Cost of Equity at Poulsbo Manufacturing, Inc. (Adair Imaging)

Poulsbo Manufacturing, Inc. (Adair Imaging) is currently an all-equity firm that pays no taxes. The market value of the firm's equity is 3 million. The cost of this unlevered equity is 15 percent annum. Poulsbo plans to issue 600000 in debt and use the proceeds to repurchase stock. The cost of debt is 4% semi annually.

Questions:
a. After Poulsbo repurchases the stock, what will the firm's weighted average cost of capital be?
b. After the repurchase, what will the cost of equity be? Explain.
c. Using MM-Proposition 2, what will be the weighted average cost of capital after the repurchase?

Solution Preview

a. After Poulsbo repurchases the stock, what will the firm's weighted average cost of capital be?

According to Modigliani-Miller the weighted average cost of capital (rWACC) for a levered firm is equal to the cost of equity for an unlevered firm in a world with no taxes. Since Poulsbo pays no taxes, its weighted average cost of capital after the restructuring will equal the cost of the firm's equity before the restructuring.

Therefore, Poulsbo's weighted average cost of capital will be 15% after the repurchase same as the cost of unlevered equity prior to repurchase.

b. After the repurchase, what ...

Solution Summary

This solution provides a detailed, step by step response of about 420 words which explains the use of the MM-Proposition 2 to calculate the WACC after stock repurchase. All calculations and the required rwacc formula has been included, with all variables explained.

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