Question

Suppose Goodyear Tire and Rubber Company has an equity cost of capital of 8​%, a debt cost of capital of 6.5​%, a marginal corporate tax rate of 32​%, and a​ debt-equity ratio of 2.6. Assume that Goodyear maintains a constant​ debt-equity ratio. a. What is​ Goodyear's WACC? b. What is​ Goodyear's unlevered cost of​ capital?   c.​ Explain, intuitively, why​ Goodyear's unlevered cost of capital is less than its equity cost of capital and higher than its WACC

Answer 1

Answer a.

Debt-Equity Ratio = 2.60

Weight of Debt = 2.60 / 3.60
Weight of Debt = 0.7222

Weight of Equity = 1.00 / 3.60
Weight of Equity = 0.2778

WACC = Weight of Debt * Cost of Debt * (1 - Tax Rate) + Weight of Equity * Cost of Equity
WACC = 0.7222 * 0.0650 * (1 - 0.32) + 0.2778 * 0.08
WACC = 0.0541 or 5.41%

Answer b.

Debt-Equity Ratio = 2.60

Weight of Debt = 2.60 / 3.60
Weight of Debt = 0.7222

Weight of Equity = 1.00 / 3.60
Weight of Equity = 0.2778

Unlevered Cost of Capital = Weight of Debt * Cost of Debt + Weight of Equity * Cost of Equity
Unlevered Cost of Capital = 0.7222 * 0.0650 + 0.2778 * 0.08
Unlevered Cost of Capital = 0.0692 or 6.92%

Answer c.

Leverage makes equity riskier as compared to overall firm, if there is no debt and that is why Cost of equity is more than the unlevered cost of capital. And, the unlevered cost of capital is higher than the WACC because cost of debt is less than the Cost of equity.