Problem
Johnson Controls (JC) is considering a change in its capital structure as a result of a decision to fund a new investment.
JC currently has 2,000 bonds outstanding with a $1,000 face value, 8 years to maturity, and 5.3% coupon rate (annual payment). The bonds are currently trading at $939.39. In addition, JC has 2 million shares issued and outstanding. They are trading at 40 per share currently.
JC is planning to issue 4,000 new bonds with a 10 year term-to-maturity to fund a new plant and repurchase its existing bonds as their covenants require their repurchase if JF dramatically changes its capital structure.
Assume the following facts:
• the current yield on 10 year Treasuries is 3.3% ,
• JC's tax rate is 40%,
• JC's asset beta is 2.1,
• currently, the estimated market risk premium is 6%;
• JC will set the coupon rate on its new debt using the bond component model so that it sells at par which it estimates to be around 200 basis points above the yield on its current debt, and
• its stock price moves to $41 per share after announcement of the investment/restructuring.
Given this information, estimate JC's current WACC and expected WACC (under the new capital structure). How would this action affect JC's earnings volatility and flexibility in the future?