Question

1.[MM I: No corporate Taxes and No bankruptcy cost] i. Sunny Korea Corp. has a debt-equity ratio of 1. Its WACC is 8% and its cost of debt (RD) is 5%. Ignoring tax, what is its cost of equity (RE)?


ii. It’s considering restructuring of a debt-equity ratio of 1.5. Calculate the WACC again.


iii. In ii, you should get a higher cost of equity, but the same WACC. Why is that?

2. In the problem 1, now consider corporate taxes of 21%.

i. What is the cost of equity (RE) when a D/E is 1? Compare with the problem 1-i. (Remind that the WACC in MM II case I is constant and the same with the unlevered cost of capital.)

ii. What is the WACC when a D/E is 1? Compare with the WACC in problem 1-i (WACC=8%).

iii. What is the cost of equity (RE) when a D/E is now 1.5? Compare with the problem 2-i.

iv. What is the WACC when a D/E is 1.5? Compare with the WACC in problem 1-ii.

Answer 1

MM 1(i);-

Debt weight(DW) = 1, Equity weight(EW) = 1, Total weight(TW) = 2

WACC = RD*DW/TW + RE*EW/TW

0.08 = 0.05*1/2 + RE*1/2 ; solving the equation we get RE = 11%

MM 1(ii);-

Debt weight(DW) = 1.5, Equity weight(EW) = 1, Total weight(TW) = 2.5 RD=5%, RE=11%(refer MM1i)

WACC = RD*DW/TW + RE*EW/TW

= 0.05*1.5/2.5 + 0.11*1/2.5

= 7.4%

MM 1(iii);-

WACC get reduced from MM 1(i) to MM 1(ii), because the debt financing is more than equity financing. Cost of debt is lower than cost of equity so that WACC get reduced to 7.4%

MM 2(i);-

Debt weight(DW) = 1, Equity weight(EW) = 1, Total weight(TW) = 2, RD (after tax) = 5%*(1-0.21) = 3.95%, WACC = 8%

WACC = RD (after tax)*DW/TW + RE*EW/TW

0.08 = 0.0395*1/2 + RE*1/2 : RE = 12.05%

MM 2(ii);-

Debt weight(DW) = 1, Equity weight(EW) = 1, Total weight(TW) = 2, RD (after tax) = 5%*(1-0.21) = 3.95%, RE=11%(refer MM1i)

WACC = RD(after tax)*DW/TW + RE*EW/TW

= 0.0395*1/2 + 0.11*1/2

= 7.475%

Comparing with MM 1(i), WACC 8% reduced to 7.475% with same debt-equity ratio but it resulted due to tax saving from debt component.

MM 2(iii);-

Debt weight(DW) = 1.5, Equity weight(EW) = 1, Total weight(TW) = 2.5, RD (after tax) = 5%*(1-0.21) = 3.95%, WACC=8%

WACC = RD(after tax)*DW/TW + RE*EW/TW

0.08 = 0.0395*1.5/2.5 + RE*1/2.5

RE = 14.075%

Comparing with MM 2(i), RE increased because debt propostion is increased.

MM 2(iv);-

Debt weight(DW) = 1.5, Equity weight(EW) = 1, Total weight(TW) = 2.5, RD (after tax) = 5%*(1-0.21) = 3.95%, RE=11%

WACC = RD(after tax)*DW/TW + RE*EW/TW

= 3.95%*1.5/2.5 + 11%*1/2.5

WACC = 6.77%

From WACC 7.4% reduced to 6.77% due to tax effect.