Question

Citee Corp. has no debt but can borrow at 6.2 percent. The firm’s WACC is currently 8.5 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 15 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 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.) d-1. If the firm converts to 15 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 40 percent debt, what is the company’s WACC?

Answer 1

Answer a.

Unlevered cost of equity = WACC if no debt
Unlevered cost of equity = 8.50%

Answer b.

Weight of debt = 15%
Weight of equity = 85%

Debt-equity ratio = Weight of debt / Weight of equity
Debt-equity ratio = 0.15 / 0.85
Debt-equity ratio = 0.17647

Cost of debt = 6.20%

Levered cost of equity = Unlevered cost of equity + (Unlevered cost of equity - Cost of debt) * (1 - Tax rate) * Debt-equity ratio
Levered cost of equity = 0.0850 + (0.0850 - 0.0620) * (1 - 0.25) * 0.17647
Levered cost of equity = 0.0850 + 0.0030
Levered cost of equity = 0.0880 or 8.80%

Answer c.

Weight of debt = 40%
Weight of equity = 60%

Debt-equity ratio = Weight of debt / Weight of equity
Debt-equity ratio = 0.40 / 0.60
Debt-equity ratio = 0.66667

Cost of debt = 6.20%

Levered cost of equity = Unlevered cost of equity + (Unlevered cost of equity - Cost of debt) * (1 - Tax rate) * Debt-equity ratio
Levered cost of equity = 0.0850 + (0.0850 - 0.0620) * (1 - 0.25) * 0.66667
Levered cost of equity = 0.0850 + 0.0115
Levered cost of equity = 0.0965 or 9.65%

Answer d-1.

WACC = Weight of debt * Cost of debt * (1 - Tax rate) + Weight of equity * Levered cost of equity
WACC = 0.15 * 6.20% * (1 - 0.25) + 0.85 * 8.80%
WACC = 8.18%

Answer d-2:

WACC = Weight of debt * Cost of debt * (1 - Tax rate) + Weight of equity * Levered cost of equity
WACC = 0.40 * 6.20% * (1 - 0.25) + 0.60 * 9.65%
WACC = 7.65%