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U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 8%, and its tax rate is 45%. It currently has a levered beta of 1.25. The risk-free rate is 2.5%, and the risk premium on the market is 8%.
U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 10%. Use the Hamada equation to unlever and relever the beta for the new level of debt. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure? (Hint: Do not round intermediate calculations.)
The optimal capital structure is the one that (maximize or Minimize) the WACC and (maximize or Minimize) the firm's stock price. Higher debt levels (increase or Decrease) the firm's risk. Consequently, higher levels of debt cause the firm's cost of equity to (increase or Decrease) .
Expert Solution
1) Computation of Value of Unlevered Beta:
Unlevered Beta = Beta/[1+(1-Tax Rate)*(Debt)/(Equity)]
= 1.25/[1+(1-45%)*(30%)/(70%)]
= 1.01
2) Computation of Levered Beta with the new capital structure:
Levered Beta = Unlevered Beta*[1+(1-Tax Rate)*(Debt)/(Equity)]
= 1.01*[1+(1-45%)*(60%)/(40%)]
= 1.85
3) Computation of Cost of Equity:
Cost of Equity = Risk Free Rate + Beta*Market Risk Premium
= 2.5% + 1.85*8%
= 17.27%
4) Computation of Weighted Average Cost of Capital:
Weighted Average Cost of Capital = After-Tax Cost of Debt*Weight of Debt + Cost of Equity*Weight of Equity
= 10%*(1-45%)*60% + 17.27%*40%
= 10.21%
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