Question

*A firm has a debt to equity ratio of 2/3. Its cost of equity
is 15.2%, cost of debt is 4%, and tax rate is 35%. Assume that the
risk-free rate is 4%, and market risk premium is 8%.*

*Suppose the firm repurchases stock and finances the
repurchase with debt, causing its debt to equity ratio to change to
3/2:*

*What is the firm’s WACC before and after the change in capital structure?**Compute the firm’s new equity beta and new cost of equity?*

Answer #1

WACC at debt to equity ratio of 2/3 = Weight of Equity * Cost of
equity + weight of Debt* Cost of Debt*(1-Tax Rate)

=3/5*15.2%+2/5*4%*(1-35%) = **10.16%**

Beta levered= Equity Premium/Market Premium = (15.2%-4%)/8% =
11.2/8 = 1.4

Beta unlevered = Beta Levered/(1+(1-Tax Rate)*Debt /Equity) =
1.4/(1+(1-35%)*2/3) =0.976744

Beta levered at 3/2 debt equity ratio = Beta unlevered *(1+(1-Tax
Rate)*Debt /Equity) =0.976744*(1+(1-35%)*3/2) = 1.929 or
**1.93**

Cost of New Equity = Risk Free + Beta * Market Risk Premium = 4% +
1.929 *8% = **19.43%**

New WACC =Weight of Equity * Cost of equity + weight of Debt* Cost
of Debt*(1-Tax Rate)

=2/5***19.43%**+3/5*4%*(1-35%) =
**9.33%**

Please Discuss in case of Doubt

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