5. The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is cur

Question

5. The Nantucket Nugget is unlevered and is valued at $640,000. Nantucket is currently deciding whether including debt in its capital structure would increase its value. The current cost of equity is 12%. Under consideration is issuing $300,000 in new debt 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 effective marginal tax bracket is zero. What will Nantucket's new WACC be? Briefly explain why?

Explanation / Answer

Currently Nantucket Nugget is unlevered having equity of $640,000.

Debt proceeds of $300,000 will be used to to repurchase equity.

Hence, equity will reduce to = 640,000 - 300,000

= $340,000

WACC = (Kd x Wd) + (Ke x We)

where,

WACC = Weighted average cost of capital

Cost of debt (Kd) = 8%

Cost of equity (Ke) = 12%

Wd = Weight of debt

We = Weight of equity

WACC = (8% x 300,000/640,000 ) + (12% x 340,000/640,000)

= 3.75% + 6.375%

= 10.125%

Due to cheaper debt in the capital structure, WACC of Nantucket Nugget will fall from 12%(when it was unlevered) to 10.125%.

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