Question

# Assume that capital markets are perfect. A firm finances its operations via \$50 million in stock...

Assume that capital markets are perfect. A firm finances its operations via \$50 million in stock with required return of 15% and \$40 million in bonds with a required return of 9%. Assuming that the firm could issue \$10 million in additional bonds at 9% and use the proceeds to reture \$10 million worth of equity, what would happen to the firm’s WACC ? What would happen to the required return on the company’s stock ?

Using MM Proposition Formula II.

rL = rA + (rA -rD )*D/E
where,
rL = required return on equity = 0.15
rA = weighted average cost of capital (wacc)
rD = required return on debt = 0.09
D/E = 40/50 = 4/5

Putting in the equation
0.15 = rA + (rA - 0.09) * 4/5
rA + 4/5rA - 0.072 = 0.15
1.8 rA = 0.222
rA = 0.1233
= 12.33%

wacc of the firm would be 12.33%

To find out the required return on stock we will use the same formula

rL = rA + (rA -rD )*D/E
now D/E = 50/40 = 5/4
rL = 0.1233 + (0.1233 - 0.09) * 5/4
= 0.1233 + 0.04167
= 16.5%

The new cost of equity would be 16.5%. Hence, the addition of \$10 million of debt would cause the equity cost to rise from 15% to 16.5%.

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