Question

Pacific Island Tours currently has a weighted average cost of capital of 12.4% based on a combination of debt and equity financing. The firm has no preferred stock. The current debt-equity ratio is 0.47 and the after-tax cost of debt is 6.1%. The company just hired a new president who is considering eliminating all debt financing. All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm?

Answer 1

Computation of current cost of equity

If debt equity ratio = 0.47

Say Debt = x

x / 1-x = 0.47

x = 0.47-0.47x

1.47x = 0.47

x = 0.3197

i.e Weight of Debt = 31.97%

Weight of Equity = 68.03% (100%-31.97%)

WACC = Cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity = 12.4%

0.061 * 0.3197 + Cost of Equity * 0.6803 = 0.124

  Cost of Equity = 15.36%

If it switches to all equity firm

Weight of Debt = 0%

Weight of Equity = 100%

WACC = Cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity = 12.4%

0.061 * 0 + Cost of Equity * 1 = 0.124

  Cost of Equity = 12.4%

i.e

if it is switches to all equity firm,

WACC = Cost of equity