Question

Remote Removals Ltd has no debt and its WACC is currently 12 per cent. Remote can borrow at 8 per cent. The corporate tax rate is 30 per cent.

a. What is Remote's cost of equity?
b. If Remote converts to 20 per cent debt, what will its cost of equity be?
c. If Remote converts to 50 per cent debt, what will its cost of equity be?
d. What is Remote's WACC in part (b)? In part (c)?

Answer 1

a

The unlevered WACC looks at a theoretical situation where there is no debt at all. In WACC, the tax part only impacts the cost of debt. Since we say there is no debt the weight of debt is zero and tax is not relevant.

So now unlevered WACC = Cost of equity.

12%

b

If debt is 20%, it will mean rest is equity (80%)

Debt equity ratio = 20%/80% = 0.25

cost of equity levered = cost of equity unlvered + D/E *((cost of equity unlevered - pretax cost of debt)*(1-tax rate))

cost of equity levered = 12% + 0.25*((12%-8%)*(1-0.30))

cost of equity levered = 12% + (0.25*(4%)*(0.70))

cost of equity levered = 12% +(0.25*(0.028))

12% + 0.7%

12.07%

c

If debt is 50%, it will mean rest is equity (50%)

Debt equity ratio = 50%/50% = 1

cost of equity levered = cost of equity unlvered + D/E *((cost of equity unlevered - pretax cost of debt)*(1-tax rate))

cost of equity levered = 12% + (1*(12%-8%)*(1-0.30)

cost of equity levered = 12% + (1*(4%)*(0.70)

cost of equity levered = 12% +(1*(0.028))

12% +2.8%

14.80%

d

20% debt 80% equity

WACC = (Cost of Debt After Tax * %age of Debt) +(Cost of Equity * %age of Equity)

((8%*(0.70)) * 20%) + ((12.7%*80%))

11.28%

50% debt 50% equity

WACC = (Cost of Debt After Tax * %age of Debt) +(Cost of Equity * %age of Equity)

((8%*(0.70)) * 50%) + ((14.8%*50%))

10.20%