Orange, Inc. is a well-known designer and manufacturer of cell phones, computers, tablets and their associated software and operating systems. Suppose that Orange, Inc. is financed with 100% equity and has a market value of $423 billion. Suppose also that Orange has a WACC of 7%. Investment bankers have approached Orange’s CFO and proposed that “Orange take advantage of historically low debt rates” by issuing bonds with a market value of $100 billion and using the proceeds to re-purchase $100 billion in equity from shareholders. Suppose that due to Orange’s large free cash flows the bonds would be almost risk free and have a beta of 0.1. Assume that the market risk premium is 5% and the risk free rate is 2%. The investment bankers have used the WACC formula
to argue that including debt in Orange’s capital structure will “lower its overall cost of capital” from 7% to 5.9% because Orange can issue (almost) risk free debt. This debt, they argue, is much cheaper than equity. That is, their calculation of the ‘new’ WACC is: [The bankers correctly note that while Orange is extremely profitable, its effective tax rate in the U.S. (the relevant jurisdiction) is zero due to a variety of initiatives
that the company has taken to shield its income from taxation and therefore does not impact the WACC]. Are the bankers correct that Orange can lower its cost of capital by replacing $100B in equity with $100B in bonds? Please use the WACC formula as the basis of your answer.