Question

Assume we are in an otherwise perfect, frictionless world with corporate taxes. Firm X has a debt-to-equity ratio of 2.25, its cost of equity is 12%, and its cost of debt is 6%. The corporate tax rate is 35%. If the firm converts to a debt-to-equity ratio of 1.25, what will its new WACC be?

Answer #1

WACC = Cost of Equity * (Equity/ (Debt +equity )) + Cost of Debt * (Debt/ (Debt +equity))* (1 -Tax Rate)

1- cost of equity = 12%, cost of debt = 6%, Tax rate = 35%

Debt to Equity = 2.25, Debt = 2.25 Equity

Debt / (Debt + Equity) = 2.25E / (2.25 E + E) = 2.25 E / 3.25 E = 2.25 / 3.25 = 0.692

E / (E + D) = E / (E + 2.25 E) = 1 / 3.25 = 0.308

WACC = 0.12 * 0.308 + .06 * 0.692 * (1 - .35) = 6.39%

For debt-to-equity ratio of 1.25

D / ( D + E) = 1.25 / 2.25 = 0.5556 , E / (D + E) = 1 / 2.25 = 0.4444

New WACC = 0.12 * 0.4444 + .06 * 0.5556 * (1 - .35) = 7.50%

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