Question

Company XYZ has a target capital structure of 30% equity and 70% debt. Its cost of equity is 10%, and cost of debt is 5%. What would happen to XYZ’s WACC if its capital structure were to shift to 40% equity and 60% debt?

wacc increases decreases or stays constant? and why

Answer 1

Step-1:Calculation of existing WACC
			Weight	Cost
			a	b	a*b
	Equity		30%	10%	3.00%
	Debt		70%	5%	3.50%
	WACC				6.50%
Step-2:Calculation of modified WACC
			Weight	Cost
			a	b	a*b
	Equity		40%	10%	4.00%
	Debt		60%	5%	3.00%
	WACC				7.00%
So, WACC increases.
Cost of equity is more than cost of debt.
When weight of equity increases,overall WACC increases because increase in weighted cost of equity(4.00%-3.00%=1.00%) is more than decrease in weighted cost of debt(3.50%-3.00%=0.50%).