Question

1. McCain Enterprises is thinking about changing its permanent capital structure from 40% debt to asset ratio to 50% debt ratio. The following information is currently available:

Cost of debt (RRR of creditors) is 7%. Tax rate is 25%. Required return on equity (cost of equity) given the 25% tax rate is 18.70%. If taxes did not exist, the RRR on equity would have been 20%. If the company switches to 50 debt the cost of debt is estimated at 8%.

1. Calculate the cost of equity after the switch to 50% debt.
2. Calculate the WACC after the switch to 50% debt.

Answer 1

a. Current Debt Ratio =40%
So Debt to Equity Ratio =Debt Ratio/(1-Debt Ratio) =40%/(1-40%) =2/3
Cost of Equity levered at 40% =Cost of Equity unlevered+(Cost of Equity Unlevered -Cost of Debt)*Debt/Equity*(1-Tax Rate)
18.70% =Cost of Equity Unlevered+(Cost of Equity Unlevered-7%)*2/3*(1-25%)
18.70% =Cost of Equity Unlevered+(Cost of Equity Unlevered-7%)*2/3*(1-25%)
18.70% =Cost of equity Unlevered+(Cost of Equity Unlevered-7%)*0.5
Cost of Equity Unlevered =(18.70%+7%*0.5)/1.5 =14.80%

New Cost of Debt =8%
New Debt equity ratio at 50% debt ratio =1:1
At 50% Debt ratio new cost of equity =Cost of Equity unlevered+(Cost of Equity Unlevered -Cost of Debt)*Debt/Equity*(1-Tax Rate) =14.80%+(14.80%-8%)*1*(1-25%) =19.90%

b. WACC =Weight of Equity*Cost of New Equity+Weight of Debt*Cost of Debt*(1-Tax Rate)
=0.5*19.90%+0.5*8%*(1-25%) =12.95%