Question

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

Answer 1

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%

= 10.51%

WACC with 80% debt = 0.80 x 7%(1-0.35) + 0.20 x 12%

= 6.04%

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-

• The company and the project have the same amount of risk
• The capital structure of the company and project are the same
• there is very less fluctuation in the market value of debt and equity so as to make the optimal capital structure of the company comparable to the actual structure

Let me know in the comment section in case of any doubt.