Question

Assume that with a capital structure of 20% debt and 80% equity the cost of debt is 10% and cost of equity is 14%. The tax rate is 40%. The current value of the business is $ 500,000. The finance manager of the company is recommending a change of capital structure to 80% debt and 20% equity. He states that at effective cost of debt of 10% the increase of debt in capital structure would always increase the value of the firm.

He further adds that the cost of equity will remain the same at any level of debt as it should not only increase the earnings but also decrease the beta of the company’s stock.

1. Do you agree with the recommendation and reasoning of the finance manager? Give three reasons as to why you agree with the reasoning?

In case you don’t agree give three reasons in support of your response

Answer 1

Current WACC = 20%*10%*(1-40%) + 80%*14% = 12.40%

The finance manager's reasoning that at effective cost of debt of 10% the increase of debt in capital structure would always increase the value of the firm - is not correct for the following reasons.

1. With increase in debt, the additional debt holders will not be ready to provide more debt at the same cost of debt i.e. the cost of debt will increase with the level of debt

2. With increased debt, the leverage risk of the firm would increase and the cashflows i.e. residual earnings to the shareholders will become more risky. Hence the cost of equity will increase. It is not possible for equityholders to have the same cost of equity at enhanced level of debt

3. The combined cost of debt and equity which will increase (at different points of debt and with different speed) will make the cost of WACC higher , thereby decreasing the value of the firm. In practice, some amount of debt is beneficial for tax benefits but beyond a certain level, it is not advisable

Further, as the variability in cashflows to equityholders become more, the earnings will be more in good situations and less when the situations are bad , thus the cost of equity shall increase as well as the Beta of the firm.