Question

Shadow Corp. has no debt but can borrow at 7.1 percent. The firm’s WACC is currently 8.9 percent, and the tax rate is 35 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.) Calculate the Cost of equity %

b. If the company converts to 25 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.) Calculate Cost of equity %

c. If the company converts to 60 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.) Cost of equity %

d-1. If the company converts to 25 percent debt, what will the company's WACC be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Calculate the WACC %

d-2. If the company converts to 60 percent debt, what will the company's WACC be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Caluclate the WACC %

Answer 1

a. What is the company’s cost of equity

Answer = Cost of equity 8.9 %

Company has no Debt and WACC = 8.9%, it means is 100% equity financed therefore cost of equity = 8.9%

For an all-equity financed company:

WACC =R0=RS= .089, or 8.9%

b. If the company converts to 25 percent debt, what will its cost of equity be?

Answer = Cost of equity 9.29%

= 0.089+(0.089 - 0.071)*(0.25 / 0.75)*(1 - 0.35)

= 0.089 + 0.0039

= 0.0929

c. If the company converts to 60 percent debt, what will its cost of equity be?

Answer = Cost of equity 10.655%

Weight of debt = 60%, then weight of equity = 1- 0.60 = 0.40

= 0.089 + (0.089 - 0.071)*(0.60 / 0.40)*(1 - 0.35)

= 0.089 + 0.01755

= 0.10655

d-1. If the company converts to 25 percent debt, what will the company's WACC be?

Answer = WACC = 8.12%

WACC = Weight of Debt * cost of debt(1- Tax rate) + Weight of equity * cost of equity

WACC = 0.25 * 7.1*(1-0.35) + 0.75 * 9.29

WACC = 0.0115375 + 0.069675

WACC = 8.12%

d-2. If the company converts to 60 percent debt, what will the company's WACC be?

ANSWER = WACC %

WACC = Weight of Debt * cost of debt(1- Tax rate) + Weight of equity * cost of equity

WACC = 0.60 * 7.1*(1-0.35) + 0.40 * 9.29

WACC = 0.02769 + 0.03716

WACC = 6.485