Question

Shadow Corp. has no debt but can borrow at 6.8 percent. The firm’s WACC is currently 8.6 percent, and the tax rate is 35 percent.

a. What is the firm’s cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity %

b. If the firm converts to 30 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity %

c. If the firm converts to 40 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity %

d-1 If the firm converts to 30 percent debt, what will the company's WACC be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC %

d-2 If the firm converts to 40 percent debt, what will the company's WACC be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC %

Answer 1

a. For an all-equity financed company: WACC = R₀ = R_S = .086, or 8.6%

b. To find the cost of equity for the company with leverage, we need to use M&M Proposition II with taxes, so:

R_S = R₀ + ( R₀ – R_B )( B / S )(1 – T_C )

R_S = .086 + (.086 – .068)(.30 / .70)(1 – .35)

R_S = .0910, or 9.10%

c. Using M&M Proposition II with taxes again, we get:

R_S = R₀ + ( R₀ – R_B )( B / S )(1 – T_C )

R_S = .086 + (.086 – .068)(.40 / .60)(1 – .35)

R_S = .0938, or 9.38%

d. The WACC with 30 percent debt is:

WACC = ( S / V ) R_S + (( B / V ) R_B (1 – T_C )

WACC = .70(.0910) + .30(.068)(1 – .35)

WACC = .0770, or 7.70%

And the WACC with 40 percent debt is:

WACC = ( S / V ) R_S + (( B / V ) R_B (1 – T_C )

WACC = .60(.0938) + .40(.068)(1 – .35)

WACC = .0740, or 7.40%