Question

Using the WACC framework, suppose that a company’s current cost of equity is 10% and that a company’s cost of debt is 6%. The tax rate is 38%. All else being equal, if the company’s cost of debt suddenly increased by two percentage points (i.e., increased from 6% to 8%), what is the most reasonable statement about what would happen to the company’s weighted average cost of capital?

A. Decrease

B. It must increase by 2%

C. Not change

D. It must decrease by 2%

E. You need to know the capital structure to get a better idea

Answer 1

Cost of Equity = re = 10%

Cost of debt = 6%

t = tax rate = 38%

WACC is calculated using the below formula

WACC = [Weight of Equity * Cost of Equity] + [Weight of debt * Cost of Debt * (1-tax rate)

Capital structure is not given in the problem to calculate weight of equity and debt

If, cost of debt is increased by 2% to understand the impact on WACC, we need to know the capital structure

Option E is correct

E. You need to know the capital structure to get a better idea