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.*

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