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

Weighted average Cost of capital = (Weight of equity)*(Cost of Equity) + (Weight of Debt)*(Cost of Debt)*(1 - Tax rate)

As Marten pays no tax, so if we shuffle the above formula, we will get the Return on debt. As 60% is the weight of debt, so equity weight will be the rest, which is 40%.

14% = (0.4) * (19%) + (0.6) * (Return on Debt)

Return on debt = 10.6667%

So the return on debt is 10.6667%

If debt to asset ratio increase to 80%, then equity weight will be 20%.

WACC = (0.2) * (19%) + (0.8) * (10.6667%)

= 12.3333%

So the new WACC will be 12.3333

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