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1. Ignore taxes and financial distress for this question. Suppose that your firm has a debt-equity ratio of 0.75, a cost of debt of 8.5%, and an unlevered cost of equity of 15%.
a. What is your firm's cost of equity and WACC?
b. If you decrease your D/E ratio to 0.50, what would your cost of equity and WACC be? Assume that your cost of debt stays at 8.5%, regardless of your debt burden.
a). Computation of the firm's cost of equity:-
Cost of equity = Unlevered cost of equity + ((Unlevered cost of equity - Cost of debt)*(D/E ratio) *(1- Tax rate))
= 15% + ((15% - 8.5%)*0.75*(1-0%))
= 15% + (6.5% * 0.75)
= 15% + 4.88%
= 19.88%
Computation of the WACC:-
Debt-to-equity ratio = 0.75
Weight of debt = 0.75 / (1+0.75)
= 42.86%
Weight of equity = 1 / (1+0.75)
= 57.14%
WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity)
= (42.86% * 8.5%) + (57.14% * 19.88%)
= 3.64% + 11.36%
= 15%
b). Computation of the cost of equity:-
Cost of equity = Unlevered cost of equity + ((Unlevered cost of equity - Cost of debt)*(D/E ratio) *(1- Tax rate))
= 15% + ((15% - 8.5%)*0.50*(1-0%))
= 15% + (6.5% * 0.50)
= 15% + 3.25%
= 18.25%
Computation of the WACC:-
Debt-to-equity ratio = 0.50
Weight of debt = 0.50 / (1+0.50)
= 33.33%
Weight of equity = 1 / (1+0.50)
= 66.67%
WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity)
= (33.33% * 8.5%) + (66.67% * 13.25%)
= 2.83% + 12.17%
= 15%
