Question

1. Isabella Publishing's tax rate is 21%, its beta is 1.40, and it currently has no debt. The CFO is considering moving to a capital structure with 25% debt and 75% equity and using the newly raised capital to repurchase shares of the common stock. If the risk-free rate is 4.5% and the market risk premium is 7.0%, by how much would the cost of equity for the levered firm increase, compared to the cost of equity of the unlevered firm? What will be the change in the WACC, if the company can borrow at 6 percent? (6 points)

Answer 1

Unlevered cost of equity = 4.5% + 1.4*7% = 14.3%

Levered beta = Unlevered beta * [1 + (1 - tax rate) * D/E]

Levered beta = 1.40 * [1 + (1 - 0.21) * 0.25/0.75] = 1.7686666667

Levered cost of equity = 4.5% + 1.7686666667 * 7%

Levered cost of equity = 0.1688066667 = 16.88066667%

Cost of equity for the levered firm increases by 0.1688066667 - 0.143 = 0.0258066667 = 2.58066667 percentage points.

WACC with no debt = Unlevered cost of equity = 14.3%

WACC with debt

WACC = 13.8455%

WACC decreases by (0.143 - 0.138455) = 0.004545 = 0.4545 percentage points