Question

Shadow Corp. has no debt but can borrow at 6.3 percent. The firm’s WACC is currently 8.6 percent and the tax rate is 21 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 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 45 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 20 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 45 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

A

When there is no debt cost of equity = WACC = 8.6%

B

D/A = 0.2

D/E = D/(A-D) = 0.2/(1-0.2) =0.25

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 9.6+0.25*(9.6-6.3)*(1-0.21)

Levered cost of equity = 10.25

C

D/A = 0.45

D/E = D/(A-D) = 0.45/(1-0.45) =0.818

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 9.6+0.8181*(9.6-6.3)*(1-0.21)

Levered cost of equity = 11.73

D-1

Weight of equity = 1-D/A

Weight of equity = 1-0.2

W(E)=0.8

Weight of debt = D/A

Weight of debt = 0.2

W(D)=0.2

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6.3*(1-0.21)

= 4.977

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.98*0.2+10.25*0.8

WACC =9.2%

D-2

Weight of equity = 1-D/A

Weight of equity = 1-0.45

W(E)=0.55

Weight of debt = D/A

Weight of debt = 0.45

W(D)=0.45

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6.3*(1-0.21)

= 4.977

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.98*0.45+11.73*0.55

WACC =8.69%