Question

A company currently has the debt-to-equity ratio of 1/3. Its cost of debt is 6% before tax and its cost of equity is 12%. Assume that the company is considering raising the debt-to-equity ratio to 1/2. The tax rate is 20%. What is its new cost of equity under the new debt-to-equity ratio? What is its new weighted average cost of capital (WACC) under the new debt-to-equity ratio.

Answer 1

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

12 = Unlevered cost of equity+0.3333*(Unlevered cost of equity-6)*(1-0.2)

Unlevered cost of equity = 10.74

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

Levered cost of equity = 10.74+0.5*(10.74-6)*(1-0.2)

Levered cost of equity = 12.64

D/A = D/(E+D)

D/A = 0.5/(1+0.5)

=0.3333

Weight of equity = 1-D/A

Weight of equity = 1-0.3333

W(E)=0.6667

Weight of debt = D/A

Weight of debt = 0.3333

W(D)=0.3333

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

After tax cost of debt = 6*(1-0.2)

= 4.8

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

WACC=4.8*0.3333+12.64*0.6667

WACC =10.03%