Question

firm a has a pre-tax cost of debt of 5%. the firm also has $10 mil in debt and $40 mil in equity. the firm's tax rate is 20% and an equity beta of 1. if the firm plans to issue $10 mil in debt next year, what will be its WACC after that issuance? assume the risk free rate is 2% and the market risk premium is 6%

a. 7.33%

b.5%

c.5.66%

d.9.47%

Answer 1

Cost of debt
Cost of debt	5.00%
Tax rate	20%
After-tax cost of debt	=5%*(1-20%)
After-tax cost of debt	4.00%
Unlevered beta from current capital structure
(B levered)=	Unlevered BETA* (1+(1-T)*(D/E))
1=	Unlevered BETA* (1+(1-20%)*(10/40))
1=	1.2*Unlevered beta
Unlevered beta=	1/1.2
Unlevered beta=	0.83
Beta after raising new loan
(B levered)=	Unlevered BETA* (1+(1-T)*(D/E))
(B levered)=	0.833* (1+(1-20%)*(20/40))
(B levered)=	1.17
Cost of equity stock
Cost of equity=	Risk free rate + beta * Market risk premium
Cost of equity=	2% + 1.1667 * 6%
Cost of equity=	9.00%
Calculation of WACC
	Cost	Capital		Weight	Weighted cost
	A	B	Weight	C=Capital component/Total capital	D=A*C
Debt	4.00%	$    20.00	=20/60	33.33%	1.33%
Equity	9.00%	$    40.00	=40/60	66.67%	6.00%
	Total capital	$    60.00		Total WACC	7.33%
Hence option A is the correct solution.