Question

Suppose Goodyear Tire and Rubber Company has an equity cost of capital of

8.18.1​%,

a debt cost of capital of

6.66.6​%,

a marginal corporate tax rate of

4545​%,

and a​ debt-equity ratio of

3.13.1.

Assume that Goodyear maintains a constant​debt-equity ratio.

a. What is​ Goodyear's WACC?

b. What is​ Goodyear's unlevered cost of​ capital?  

c.​ Explain, intuitively, why​ Goodyear's unlevered cost of capital is less than its equity cost of capital and higher than its WACC.

Answer 1

a). WACC = [wD x kD x (1 - t)] + [wE x kE]

= [(3.1/4.1) x 6.6% x (1 - 0.45)] + [(1/4.1) x 8.1%] = 2.74% + 1.98% = 4.72%

b). r = [wD x kD] + [wE x kE]

= [(3.1/4.1) x 6.6%] + [(1/4.1) x 8.1%] = 4.99% + 1.98% = 6.97%

c). Unlevered cost of capital is less than equity cost of capital because the equity bears a greater portion of the asset’s risk than debt. So as you increase debt, the equity becomes more risky and that increases the equity cost of capital.

Unlevered cost of capital is higher than WACC due to tax benefit of debt, which is included in WACC.