Question

You are a CFO considering the impact that you could have on your firm if you could lower your WACC. You would like to lower your WACC by 20% of its current level. You currently have 30% debt in your capital structure with a before-tax cost of 8.5% and a beta of 0.25, and an equity cost of 15.64%. The risk-free rate is 5% and your current equity beta is 0.76. Your firm has invested in three projects, with 30% in project 1 (beta of 1.1), 30% in project 2 (beta of 0.8), and 40% in project 3 (beta of 0.2175). The tax rate is 40%. If you increase the debt in your capital structure to 90%, will you have met your goal of lowering your WACC? Show all of your work (support your answer).

Answer 1

Current WACC=

(Wt.d*kd*(1-Tax Rate))+(Wt.e*ke)

ie.(30%*8.5%*(1-40%))+(70%*15.64%)=

12.48%

Lowering the above WACC by 20% will mean, the target WACC is

12.48%*(1-20%)=

9.98%

Now,

We will find the cost of equity at 90% debt level

Unlevered beta=Levered beta/(1+((1-Tax rate)*Debt/Equity)

ie. UnL Beta=0.76/(1+((1-40%)*30%/70%)=

0.6045

Now the levered equity beta at 90% debt level=

Levered bet=Unlevered beta*(1+((1-Tax rate)*Debt/Equity)

ie.0.6045*(1+(1-40%)*90%/10%))=

3.87

To find the market risk premium,

using CAPM,

ke=RFR=(Beta*Market Risk premium)

15.64%=5%+(0.76*MRP)

so, MRP=(15.64%-5%)/0.76=

14.00%

Now, the cost of Equity , at 90% debt level is

ke=RFR+(Beta*MRP)

5%+(3.87*14%)=

59.18%

so, the new WACC will be

(90%*8.5%*(1-40%))+(10%*59.18%)=

10.51%

So the

goal of lowering your WACC has not been met , as

10.51% > the desired 9.98%