Question

Suppose Goodyear Tire and Rubber Company has an equity cost of capital of 8.2​%, a debt cost of capital of 6.7​%, a marginal corporate tax rate of 40​%,

and a​ debt-equity ratio of 2.8. Assume that Goodyear maintains a constant​ debt-equity ratio.

a. What is​ Goodyear's WACC?

b. What is​ Goodyear's unlevered cost of​ capital?  

c.​ Explain, intuitively, why​ Goodyear's unlevered cost of capital is less than its equity cost of capital and higher than its WACC

Answer 1

a.
WACC	Cost of debt*Weight of debt + Cost of equity*Weight of equity
Calculation of weight of debt and equity
Debt	2.80	73.68%	2.80/3.80
Equity	1.00	26.32%	1/3.80
	3.80
Calculation of WACC
WACC	(0.067*(1-0.40)*0.7368)+(0.082*0.2632)
WACC	0.0402*0.7368+(0.082*0.2632)
WACC	5.12%
b.
Unlevered cost of capital	Cost of equity*(Equity to value ratio) + Cost of debt*(Debt to value ratio)
Unlevered cost of capital	(0.082*0.2632)+(0.067*0.7368)
Unlevered cost of capital	7.09%
c.
Unlevered cost of capital is less than cost of equity because equity bears higher part of asset's risk then debt/
Thus with increase in debt the value of equity would become more risky which would increase cost of capital
Unlevered cost of capital is higher than WACC is because of tax benefit which is part of WACC.