Question

Shadow Corp. has no debt but can borrow at 7%. The firm’s WACC is currently 11%, and the tax rate is 35%.

a. What is Shadow’s cost of equity?

b. If the firm converts to 25% debt, what will its cost of equity be?

c. If the firm converts to 50% debt, what will its cost of equity be?

d. What is Shadow’s WAACC in part (b)? In part (c)?

Answer 1

A. Shadow corp's cost of equity is the WACC as there is no debt in the capital structure i.e. 11%.

B. If the firm converts to 25% debt, the weight of debt becomes 0.25 and the weight of equity becomes 0.75.

Kd = 7(1- 0.35) = 4.55 %

WACC = Kd *wd + Ke*we

11% = 4.55% * 0.25 + Ke*0.75

On solving we get Ke = (11% - 4.55%)/0.75 = 8.6%

C. Using the above process we have the weights for equity and debt as 0.50 each.

Using the WACC equation, 11% = Ke * 0.50 + 4.55% * 0.50

Ke = (11% - 4.55%)/0.50 = 12.9%

D. The WACC shall remain the same for the firm i.e. 11% as equity is being converted to debt and no additional debt is used.