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[Q1-5] The debt-to-equity ratio of your firm is currently 1/2. Under this capital structure, the cost...

[Q1-5] The debt-to-equity ratio of your firm is currently 1/2. Under this capital structure, the cost of equity is 12%. You are planning to change your firm’s capital structure so that the new debt-to-equity ratio becomes 2. The change in the debt-to-equity ratio is expected to be permanent. Assume that regardless of the firm’s capital structure, the cost of debt is 6% and the corporate tax rate is 40%.

What is the WACC under the current capital structure?

	A.	10%
	B.	18%
	C.	9.2%
	D.	8.4%

What is the firm’s unlevered cost of capital?

	A.	18%
	B.	10%
	C.	9.2%
	D.	8.4%

What is the firm’s cost of equity under the new capital structure?

	A.	10%
	B.	18%
	C.	8.4%
	D.	9.2%

What is the WACC under the new capital structure?

	A.	9.2%
	B.	18%
	C.	8.4%
	D.	10%

The new WACC is _______ than the old WACC due to _______.

	A.	lower; a lower tax benefit of debt
	B.	lower; a higher tax benefit of debt
	C.	higher; a lower tax benefit of debt
	D.	higher; a higher tax benefit of debt

Expert Solution

WACC under current capital Structure = E/D+E * 12 + D/D+E * 6(1-.40)

= 200/300 * 12 + 100/300 * 3.6 (Assumed total D+E = 300, given D/E = 1/2)

= 8+1.2

= 9.2%

So, the first answer is option C - 9.2%

The firm’s unlevered cost of capital

(where we consider the company does not have any debt) = 12%+6% = 18% (as no tax shield will be there)

So, the second answer is option A - 18%

The firm’s cost of equity under the new capital structure, where D/E is 2, will be 18% (12/2 * 3) as for lesser equity more will be the cost.

So, the third answer is option B - 18%

The WACC under the new capital structure will be as follows :-

WACC under new capital Structure = E/D+E * 18 + D/D+E * 6(1-.40)

= 100/300 * 18 + 200/300 * 3.6 (Assumed total D+E = 300, given D/E = 2/1)

= 6+2.4

= 8.4%

So, the fourth answer is option C - 8.4%

The new WACC is _______ than the old WACC due to _______.

Answer to fifth question: option B - lower; a higher tax benefit of debt

This is because with higher debt in the capital structure, higher tax benefit is availed, hence the new WACC will be lower compared to the current WACC.

jeff jeffy answered 1 year ago

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