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.