Question

Mandarin is financed 80% by common stock and 20% by bonds. The expected return on the common stock is 16% and the rate of interest on the bonds is 8%. Assume that the bonds are default-free and that there are no taxes. Now assume that Mandarin's issues more debt and uses the proceeds to retire equity. The new financing mix is 20% equity and 80% debt.

If the debt is still default-free, what happens to the expected rate of return on equity? (Round your answer to 2 decimal places.)
Expected rate of return on equity   %
What happens to the expected return on the package of common stock and bonds? (Round your answer to 2 decimal places.)
Expected return on the package of common stock and bonds    %

Answer 1

1)

old D/E = 0.2/0.8 = 0.25

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

16 = Unlevered cost of equity+0.25*(Unlevered cost of equity-8)*(1-0)

Unlevered cost of equity = 14.4

new D/E = 0.8/0.2 = 4  

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 14.4+4*(14.4-8)*(1-0)

Levered cost of equity = 40

2)

D/A = D/(E+D)

D/A = 4/(1+4)

=0.8

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8*(1-0)

= 8

Weight of equity = 1-D/A

Weight of equity = 1-0.8

W(E)=0.2

Weight of debt = D/A

Weight of debt = 0.8

W(D)=0.8

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=8*0.8+40*0.2

WACC% = 14.4