Question

Gamer Co. has no debt. Its cost of capital is 10.6 percent. Suppose the company converts to a debt–equity ratio of 1. The interest rate on the debt is 7.7 percent. Ignore taxes for this problem.

What is the company’s new cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity             %

What is its new WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

WACC

Answer 1

New Cost of Equity

Currently, company has no debt, i.e., it is unlevered and we are given the unlevered cost of capital or equity (since it has no debt) as 10.6%. We need to find the Levered cost of equity, i.e., when the company gets debt in its capital.

As per MM proposition II without taxes -

Levered or New Cost of Equity = Unlevered Cost of Equity + [ (Unlevered cost of equity - cost of debt) x debt - equity ratio ]

or, New Cost of Equity = 10.6% + [ (10.6% - 7.7%) x 1 ] = 13.50%

WACC

If Debt - equity = Debt / Equity = 1 or 1 / 1

This means, weight of debt = weight of equity = 0.5

WACC = Weight of Equity x New cost of equity + Weight of debt x Cost of debt = 0.5 x 13.50% + 0.5 x 7.7% = 10.60%