Question

A company currently has the debt-to-equity ratio of 1/3. Its cost of debt is 4% 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

	rS = r0 + (B/S)(r0 – rB)(1 – TC)
	r0	= the cost of equity for an unlevered firm
	rS	= the cost of equity for a levered firm
	rB	= the pre-tax cost of debt
	TC	= the corporate tax rate
	B/S	= the firm’s debt-to-equity ratio
	rs = 0.12+0.5(0.12-0.04)(1-0.2)
	rs = 0.12+0.032
	rs = 0.152 ~ 15.20%
rwacc	= {B / (B+S)}(1 – TC) rB + {S / (B+S)}rS
New WACC = (0.5) (1-0.2)(0.04)+ (0.5) (0.152)
New WACC = 0.016+ 0.076
New WACC =0.092 ~ 9.2%