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

We will first calculate the current WACC as shown below-

Let us also caluclate Risk premium using cost of equity formula as shown below-

We will now calculate the revised cost of equity due to changed D/E ratio of 90% as shown below-

New WACC is calculated as below-

Thus New WACC of 6.01% is less than previous WACC of 12.48% by more than 20%. Thus we have succeded in meeting our goal by increasing debt.