Question

Braxton Corp. has no debt but can borrow at 7.6 percent. The firm’s WACC is currently 9.4 percent, and the tax rate is 35 percent.

  

a.	What is the company’s cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Cost of equity

%

  

b.	If the firm converts to 25 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Cost of equity

%

  

c.	If the firm converts to 50 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

  

Cost of equity

%

  

d-1	If the firm converts to 25 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.)

  

WACC

%

  

d-2	If the firm converts to 50 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.)

  

WACC

%

Answer 1

Answer a.

Unlevered Cost of Equity = Current WACC
Unlevered Cost of Equity = 9.40%

Answer b.

Weight of Debt = 0.25

Weight of Equity = 1 - Weight of Debt
Weight of Equity = 1 - 0.25
Weight of Equity = 0.75

Debt-Equity Ratio = Weight of Debt / Weight of Equity
Debt-Equity Ratio = 0.25 / 0.75
Debt-Equity Ratio = 1 / 3

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.0940 + (0.0940 - 0.0760) * (1 - 0.35) * (1 / 3)
Levered Cost of Equity = 0.0940 + 0.0039
Levered Cost of Equity = 0.0979 or 9.79%

Answer c.

Weight of Debt = 0.50

Weight of Equity = 1 - Weight of Debt
Weight of Equity = 1 - 0.50
Weight of Equity = 0.50

Debt-Equity Ratio = Weight of Debt / Weight of Equity
Debt-Equity Ratio = 0.50 / 0.50
Debt-Equity Ratio = 1

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.0940 + (0.0940 - 0.0760) * (1 - 0.35) * 1
Levered Cost of Equity = 0.0940 + 0.0117
Levered Cost of Equity = 0.1057 or 10.57%

Answer d.

WACC = Weight of Debt * Cost of Debt * (1 - Tax Rate) + Weight of Equity * Cost of Equity
WACC = 0.25 * 7.60% * (1 - 0.35) + 0.75 * 9.79%
WACC = 1.24% + 7.34%
WACC = 8.58%

Answer e.

WACC = Weight of Debt * Cost of Debt * (1 - Tax Rate) + Weight of Equity * Cost of Equity
WACC = 0.50 * 7.60% * (1 - 0.35) + 0.50 * 10.57%
WACC = 2.47% + 5.29%
WACC = 7.76%