Question

Marten Corp has a 12% WACC with a 15% expected return on equity and a 80% debt-to-asset ratio. If Marten pays no income tax, what is the return on debt? If the debt-to-asset ratio decreases to 30%, now what is Marten’s WACC?

Answer 1

Debt to Assets ratio= Debt/Assets, given as 80%

Therefore, weight of debt (Wd) in capital = 80% and weight of equity (We) = 1-80% = 20%

WACC= We*Re + Wd*Rd*(1-T)

Where Re= Return on equity (given as 15%), Rd= Return on debt and T= Tax rate (given as Nil)

Also given, WACC= 12%

Substituting the values, 12%= 20%*15% + 80%*Rd

Therefore, return on debt Rd=[0.12-(0.20*0.15)]/0.80 = 0.09/0.8 = 0.1125 or, 11.25%

If the debt to assets ratio decreases to 30%,

New Wd= 30% and new We= 70%

Therefore, WACC= 0.70*0.15 + 0.30*0.1125 = 0.105 + 0.03375 = 0.13875 or, 13.875%