Question

1.   Chandeliers has no debt but it can borrow at 6.1%.   The firm has a WACC of 9.5% and tax rate is 35%.

a) What’s the firm’s cost of equity?

b) If the firm converts to 25% debt, what the equity cost will be?

c) If the firm converts to 50% debt, what the equity cost will be?

d) What’s the firm’s WACC at 25% debt?

e) What’s the firm’s WACC at 50% deb

Answer 1

WACC is calculated using the formula: (Cost of equity*% of equity)+(Cost of debt*% of debt*(1-tax rate)).

a).

Given that WACC is 9.5%, cost of debt= 6.1% and tax rate= 35%

As the firm has no debt, % of equity is 100%. So, using the WACC formula,

WACC= (Cost of equity*% of equity)+(Cost of debt*% of debt*(1-tax rate))

9.5%= (Cost of equity*100%)+0

So, Cost of equity= 9.5%

b).

To find the cost of equity, we need to use M&M proposition ll with taxes,

Re= Ru+ (Ru-Rd)*(D/E)*(1-t)

Re= 0.095+ (9.5%-6.1%)*(0.25/0.75)*(1-0.35)

Re= 10.24%

c).

using the formula mentioned above with 50% debt,

Re= 0.095+ (9.5%-6.1%)*(0.5/0.5)*(1-0.35)

Re= 11.71%

d).

WACC with 25% debt,

WACC= (Cost of equity*% of equity)+(Cost of debt*% of debt*(1-tax rate))

WACC= (10.24%*0.75)+(6.1%*0.25*(1-0.35))

WACC= 8.67%

e).

WACC with 50% debt,

WACC= (Cost of equity*% of equity)+(Cost of debt*% of debt*(1-tax rate))

WACC= (11.71%*0.5)+(6.1%*0.5*(1-0.35))

WACC= 7.84%