Question

Shadow Corp. has no debt but can borrow at 6.7 percent. The firm’s WACC is currently 8.9 percent and the tax rate is 25 percent. a. What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. If the firm converts to 40 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) c. If the firm converts to 65 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) d-1. If the firm converts to 40 percent debt, what is the company’s WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) d-2. If the firm converts to 65 percent debt, what is the company’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Shadow Corp. has no debt but can borrow at 6.7 percent. The firm’s WACC is currently 8.9 percent and the tax rate is 25 percent. a. What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity = Cost of unlevered equity = Keu = 8.90% (As the firm doesn't have any debt currently, the WACC is cost of equity)

b. If the firm converts to 40 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Kd = 6.7%; D / E = 40% / (1 - 40%) = 2/3

Cost of levered equity = Keu + (Keu - Kd) x D / E = 8.90% + (8.90% - 6.7%) x 2 / 3 = 10.37%

c. If the firm converts to 65 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Kd = 6.7%; D / E = 60% / (1 - 60%) = 3/2

Cost of levered equity = Keu + (Keu - Kd) x D / E = 8.90% + (8.90% - 6.7%) x 3 / 2 = 12.20%

d-1. If the firm converts to 40 percent debt, what is the company’s WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC = 40% x Kd + (1 - 40%) x Cost of levered equity = 40% x 6.7% + 60% x 10.37% = 8.90%

d-2. If the firm converts to 65 percent debt, what is the company’s WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC = 60% x Kd + (1 - 60%) x Cost of levered equity = 60% x 6.7% + 40% x 12.20% = 8.90%