Question:

Pennington Airlines currently has a beta of 1.2. The companys capital

structure consists of $7 million of equity and $3 million of debt. The
company is considering changing its capital structure by increasing its
debt by $2 million and repurchasing common stock. After the plan is
completed, the company will have $5 million of debt and $5 million of
equity. The company estimates that if it goes ahead with the plan, its
bonds will have a nominal YTM of 8.5%. The companys tax rate is 40%.
The risk-free rate is 6% and the market risk premium is 7%. What is the
companys estimated WACC if it recapitalizes?
Solution: Computation of Weighted Average cost of capital
In this case we first calculate beta with no debt and the new cost of capital with the
new capital structure before you can calculate the firms Weighted Average Cost of
Capital.
Step 1:
equation:

Calculate the firms unlevered beta using the Hamada

bL

= bU[1 + (1 - T)(D/E)]

1.2

= bU[1 + (0.6)($3/$7)]

1.2

= 1.2571bU

bU

= 0.954545.

Step 2:

Calculate the firms new beta with the new capital structure:

bL = bU[1 + (1 - T)(D/E)]
bL = 0.954545[1 + (0.6)($5/$5)]
bL = 1.5273.
Step 3:
Calculate the firms new cost of equity with the new capital
structure:
ks = kRF + (RP)b
ks = 6% + 7%(1.5273)
ks = 16.6909%.
Step 4:

Calculate the firms new WACC:

WACC = wdkd(1 - T) + wcks

WACC = 0.5(8.5%)(0.6) + 0.5(16.6909%)

WACC = 10.8955% or 10.90%.
Hence the Weighted Average Cost of Capital is 10.90%