Question

Cosmetics currently has 40% debt and 60% equity (with no
preferred

stock). Their current beta is 1.70. The company is considering
splitting its debt in half (to

20%) or paying it all off. Their current debt rate is 6.00% and, if
they reduce to 20% their

bank will give them a 5.00% rate. Calculate the WACC for each of
the three debt levels.

Which debt level should the company pursue? The risk-free rate is
3.60% and the market

risk premium is 4.80%.

Answer #1

first let us know the rate of equity capital as per capm:

risk free rate + beta *(risk premium)

=>3.60% + 1.70*(4.80%).

=>11.76%.

now,

WACC under different situations:

weight of equity | weight of debt | WACC | |

current situation | 0.60 | 0.40 | (0.60*0.1176) + (0.40*0.06) =>0.07056+0.024 =>0.09456=>9.46% |

splitting into half | 0.80 | 0.20 | (0.80*0.1176)+(0.20*0.05)=>0.09408+0.01=>0.10408=>10.41% |

paying it off | 1.00 | 0.00 | (1.00*0.1176) +(0.00*0.05) =>0.1176 =.11.76% |

if the company follows existing weightage of 60% equity and 40% debt, its WACC will be less.

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