Question

Shadow Corp. has no debt but can borrow at 5.85%. The firm's WACC is currently 9.2%, and the tax rate is 35%.

a. What is the firm's cost of equity?

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

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

d. What is the firm's WACC in part (b)? In part (c)?

Answer 1

a. Firm's Current cost of Equity = WACC = 9.2%

b. Cost of Levered Equity = Cost of Unlevered Equity + Debt.Equity*(Cost of Unlevered Equity - Cost of Debt) =
=9.2%+25/75*(9.2%-5.85%) = 10.32%

c. Cost of Levered Equity = Cost of Unlevered Equity + Debt.Equity*(Cost of Unlevered Equity - Cost of Debt) =
=9.2%+50/50*(9.2%-5.85%) = 12.55%

d. WACC = Weight of Debt* Cost of Debt*(1-Tax Rate) + Weight of Equity * Cost of equity
WACC in part B = 25%*5.85%*(1-35%)+75%*10.32% = 8.69%
WACC in part c = 50%*5.85%*(1-35%)+50%* 12.55% = 8.18%

Please Discuss in case of Doubt

Best of Luck. God Bless
Please Rate Well