Question

Question 1: [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.	8.4%
	B.	10%
	C.	18%
	D.	9.2%

QUESTION 2

What is the firm’s unlevered cost of capital?

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

QUESTION 3

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

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

QUESTION 4

What is the WACC under the new capital structure?

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

QUESTION 5

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

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

Please help answer the above questions and show work.

Answer 1

What is the WACC under the current capital structure?

WACC = weight of debt * after tax cost of debt + weight of equity * cost of equity

WACC = 0.5/1.50 * 6%*0.60 + 1/1.50 * 12%

WACC = 9.2% Option D

What is the firm’s unlevered cost of capital?

Unlevered Cost of Capital = Levered Cost of Capital - (Unlevered cost of capital - Cost of Debt) * DE Ratio

Unlevered Cost of Capital = 12% - (Unlevered cost of capital - 6%) * 0.50

Unlevered Cost of Capital = 12% - 0.50 * Unlevered cost of capital + 3%

1.50 * Unlevered Cost of Capital = 15%

Unlevered Cost of Capital = 10% Option B

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

levered Cost of Capital = UnLevered Cost of Capital + (Unlevered cost of capital - Cost of Debt) * DE Ratio

levered Cost of Capital = 10% + (10% - 6%) * 2

levered Cost of Capital = 18% Option A

What is the WACC under the new capital structure?

WACC = weight of debt * after tax cost of debt + weight of equity * cost of equity

WACC = 2/3 * 6% *60% + 1/3 * 18%

WACC = 8.4% Option B

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

New WACC is Lower than the old WACC due to higher tax benefit of debt Option A

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