Question

Glacier Inc. has no long-term debt. Its cost of equity is 20%, and its marginal tax rate is 0.34. The board of directors decided to change its capital structure such that the debt/equity ratio becomes 0.7. The company can borrow at an interest rate of 4%.

1. What was the WACC before the restructuring?

2. What is the new cost of equity?

3. What is the new WACC?

Answer 1

1

WACC before restructing = cost of equity = 20%

2

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 20+0.7*(20-4)*(1-0.34)

Levered cost of equity = 27.39

3

D/A = D/(E+D)

D/A = 0.7/(1+0.7)

=0.4118

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 4*(1-0.34)

= 2.64

Weight of equity = 1-D/A

Weight of equity = 1-0.4118

W(E)=0.5882

Weight of debt = D/A

Weight of debt = 0.4118

W(D)=0.4118

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=2.64*0.4118+27.39*0.5882

WACC% = 17.2