A corporate (taxed at 35%) has a financing structure made of 70% debt and 30% equity. The debt is borrowed at 7.0% from the bank, and the cost of equity is deemed to be 12%.
a) Calculate the WACC of this firm
b) Simulate what the WACC would be if debt was made to represent 20% or 80% of the capital structure. Explain the outcome and draw the necessary conclusions as to the optimal capital structure.
c) Explain under which 3 conditions the WACC of a company can be used as the discount rate to assess the financial validity of investment projects
A) WACC = We x Re + Wd x Rd (1-tax
= 0.30 x 12% + 0.70 x 7%(1-0.35)
WACC = 6.79%
B) WACC with 20% debt = 0.20 x 7%(1-0.35) + 0.80 x 12%
WACC with 80% debt = 0.80 x 7%(1-0.35) + 0.20 x 12%
You should select the weight with the lowest WACC. Hence the optimal capital structure includes 80% debt and 20% equity.
C) the WACC of the company can be used to evaluate projects under the following condition-
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