Question

Marten Corp has a 14% WACC with a 19% expected return on equity and a 60% debt-to-asset ratio. If Marten pays no income tax, what is the return on debt? If the debt-to-asset ratio increases to 80%, now what is Marten’s WACC?

Answer 1

If there are no income taxes

WACC = Debt to asset ratio* return on debt + Equity to asset ratio * return on equity

=> 14% = 60%*return on debt + 40% * 19%

=>0.6*return on debt = 0.14-0.076 =0.064

=> return on debt = 0.106667 or 10.67%

Following the MM proposition, the WACC will remain the same as the levered return on equity will increase with increasing debt to assset ratio

levered return on equity = WACC + (WACC -return on debt) * Debt to Equity ratio

= 14%+(14%-10.667%)*80%/20%

= 27.33%

So WACC = 80%*10.67%+ 20%*27.33% =14%

however, if the return on equity is assumed not to change with leverage, then

WACC = 80%*10.67%+ 20%*19% =12.33%