Question

Malkin Corp. has no debt but can borrow at 8.25 percent. The firm’s WACC is currently 15 percent, and there is no corporate tax.

a. What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to the nearest whole number, e.g., 32.)

b. If the firm converts to 20 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 55 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. What is the company’s WACC in parts (b) and (c)? (Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

Answer 1

Ans.

a. What is the company’s cost of equity?

Cost of equity for a debt-free firm = WACC = 15%

b. If the firm converts to 20 percent debt, what will its cost of equity be?

By using M&M Proposition I with no taxes

Re = Ra + (Ra – Rd )(D/E)

Ra = 15%

Rd = 8.25%

D/E = 0.2/0.8 = 0.25

Re = 0.15 + ( 0.15 - 0.0825) ( 0.20 / 0.80)

Re = 0.15 + 0.0675 * 0.25

Re = 0.15 + 0.016875 = 0.166875 or 16.69%

c. If the firm converts to 55 percent debt, what will its cost of equity be?

By using M&M Proposition I with no taxes

Re = Ra + (Ra – Rd )(d/e)

Ra = 15%

Rd = 8.25%

D/E = 0.55/0.45 = 1.2222222

Re = 0.15 + ( 0.15 - 0.0825) ( 0.55 / 0.45)

Re = 0.15 + 0.0675 * 1.22222222

Re = 0.15 + 0.0825 = 0.2325 or 23.25%

d. What is the company’s WACC in parts (b) and (c)?

WACC with 20% debt and 80% equity is:

=Wd * Kd + We * Ke

= 0.2 * 0.0825 + 0.8 * 0.1669

= 0.0165 + 0.13352 = 0.15002 or 15%

WACC with 55% debt and 45% equity is:

=Wd * Kd + We * Ke

= 0.55 * 0.0825 + 0.45 * 0.2325

= 0.045375 + 0.104625 = 0.15 or 15%