Question

Suppose the debt ratio (Debt to total assets) is 30%, the current cost of debt is 8%, the current cost of equity is 15%, and the tax rate is 21%. A decrease in the debt ratio to 25% would decrease the weighted average cost of capital (WACC).

a. True

b. False

Answer 1

Cost of debt after-tax=8(1-tax rate)

=8*(1-0.21)=6.32%

a.Debt to assets ratio=debt/Total assets

Debt=0.3*Total assets

Let Total assets be $x

Debt=$0.3x

Total assets=Total liabilities+Total equity

Total equity=x-0.3x

=0.7x

Current WACC=Respective cost*Respective weight

=(0.3x/x*6.32)+(0.7x/x*15)

=12.396%

b.Debt to assets ratio=debt/Total assets

Debt=0.25*Total assets

Let Total assets be $x

Debt=$0.25x

Total assets=Total liabilities+Total equity

Total equity=x-0.25x

=0.75x

Now WACC=Respective cost*Respective weight

=(0.25x/x*6.32)+(0.75x/x*15)

=12.83%

Hence there would be an increase in WACC.

Hence the statement is False.