Question

Company C’s cost of equity and cost of debt are 12 and 8 percent, respectively. The current tax rate is 40 percent. Company C has a debt-to-equity ratio of 50 percent. What is Company C’s weighted average cost of capital? How would it change if the company plans to reduce its debt-to-equity ratio to 40%, increase to 60%?

Answer 1

Debt-to-equity ratio of 50%

Weighted average cost of capital = (Ke x Equity ) / (Debt + Equity) + {Kd x (1-t)}x debt} / (debt + equity)

= [0.12 x 100/150] + [{0.08 (1-0.4)} x 50/150] = 9.6%

Debt-to-equity ratio of 40%

Weighted average cost of capital = (Ke x Equity ) / (Debt + Equity) + {Kd x (1-t)}x debt} / (debt + equity)

= [0.12 x 100/140] + [{0.08 (1-0.4)} x 40/140] = 9.94%

Debt-to-equity ratio of 60%

Weighted average cost of capital = (Ke x Equity ) / (Debt + Equity) + {Kd x (1-t)}x debt} / (debt + equity)

= [0.12 x 100/160] + [{0.08 (1-0.4)} x 60/160] = 9.30%