Question

Shadow Corp. has no debt but can borrow at 6.2 percent. The firm’s WACC is currently 8.5 percent and the tax rate is 25 percent.

a.	What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	If the firm converts to 15 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c.	If the firm converts to 40 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
d-1.	If the firm converts to 15 percent debt, what is the company’s WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
d-2.	If the firm converts to 40 percent debt, what is the company’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

a) Cost of equity, if company has no debt :

Company has capital 100% in equity only & nil amount in debt. So, company's cost of equity will be equals to its wacc.

Here, wacc = 8.50%

Hence, Cost of equity = 8.50%

b) Cost of equity, if converts to 15% debt :

Weight of debt = 15% or 0.15

Weight of equity = 1 - Debt = 1 - 0.15

Weight of equity = 0.85 or 85%

Old cost of equity (refer a) = 8.50% or 0.085

Now,

New cost of equity = Weight of equity * Old cost of equity

New cost of equity = 0.85 * 0.085

New cost of equity = 0.0723 or 7.23%

c) Cost of equity, if converts to 40% debt :

Weight of debt = 40% or 0.40

Weight of equity = 1 - Debt = 1 - 0.40

Weight of equity = 0.60 or 60%

Old cost of equity (refer a) = 8.50% or 0.085

Now, Cost of equity = Weight of equity * old cost of equity

Cost of equity = 0.60 * 0.085

Cost of equity = 0.051 or 5.10%

d) 1) WACC if 15% debt :

Weight of debt = 15% or 0.15

Weight of equity = 1 - 0.15 = 0.85

Cost of debt (given) = 6.20% or 0.062

Cost of equity (refer b) = 0.0723 or 7.23%

Tax rate = 25% or 0.25

Now

New WACC = (Weight of debt * Cost of debt * (1 - Tax rate)) + (Weight of equity * Cost of equity)

New WACC = (0.15 * 0.062 * (1 - 0.25)) + (0.85 * 0.0723)

New WACC = (0.15 * 0.062 * 0.75) + 0.0615

New WACC = 0.0070 + 0.0615

New WACC = 0.0685 or 6.85%

d) 2) WACC if 40% debt :

Weight of debt = 40% or 0.40

Weight of equity = 1 - 0.40 = 0.60

Cost of debt (given) = 6.20% or 0.062

Cost of equity (refer c) = 5.10% or 0.051

Tax rate = 25% or 0.25

Now,

New WACC = (Weight of debt * Cost of debt * (1 - Tax rate)) + (Weight of equity * Cost of equity)

New WACC = (0.40 * 0.062 * (1 - 0.25)) + (0.60 * 0.051)

New WACC = (0.40 * 0.062 * 0.75) + 0.0306

New WACC = 0.0186 + 0.0306

New WACC = 0.0492 or 4.92%