Question

	Debt Capital		Equity Capital
Plan	Percentage	Rate,%	Percentage	Rate,%
1	100	16.6	-	-
2	70	13.1	30	7.8
3	65	10.8	35	7.8
4	50	10.8	5	7.9
5	35	9.7	65	9.8
6	20	7.6	80	12.5
7	-	-	100	12.5

Seven different financing plans with their D-E mixes and costs of debt and equity capital for a new innovations project are summarized below. Use the data to determine what mix of debt and equity capital will result in the lowest WACC.

D-E mix of_____ %–_____ % has the lowest WACC value.

Answer 1

WACC = {E/(D+E)} * rE+ {D/(D+E)} * rD

Where:

WACC = Weighted Average Cost of Capital

E = Total Equity

D = Total Debt

rE = Cost of Equity

rD = Cost of Debt

Plan	Debt capital		Equity Capital			WACC
	Percentage	Rate	Percentage	Rate
1	100	16.6	0	0		16.6%
2	70	13.1	30	7.8		11.51%
3	65	10.8	35	7.8		9.75%
4	50	10.8	50	7.9		9.35%
5	35	9.7	65	9.8		9.765%
6	20	7.6	80	12.5		11.52%
7	0	0	100	12.5		12.5%

D-E mix of 10.8 % – 7.9% has the lowest WACC value. {plan 4 }

Calculation shown below:

Plan - 4

WACC = {E/(D+E)} * rE+ {D/(D+E)} * rD

E = Total Equity = 50

D = Total Debt = 50

rE = Cost of Equity = 7.9%

rD = Cost of Debt = 10.8%

WACC = {50/(50+50)}*7.9% + {50/(50+50)}*10.8%

= {50/100}*7.9% + {50/100}*10.8%

=3.95% + 5.4%

= 9.35%

(All calculations are similar – for your understanding I will show one more calculation)

Plan 2 :

WACC = {E/(D+E)} * rE+ {D/(D+E)} * rD

E = Total Equity = 30

D = Total Debt = 70

rE = Cost of Equity = 7.8%

rD = Cost of Debt = 13.1%

WACC = {E/(D+E)} * rE + {D/(D+E)} * rD

WACC = {30/(70+30)}*7.8% + {70/(70+30)}*13.1%

= {30/100}*7.8% + {70/100}*13.1%

=2.34% + 9.17%

= 11.51%