Question

Irving Corp. has no debt but can borrow at 7 percent. The firm’s WACC is currently 13 percent, and there is no corporate tax.

a. What is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to the nearest whole number, e.g., 32.)

b. If the firm converts to 30 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

c. If the firm converts to 45 percent debt, what will its cost of equity be? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

d. What is the company’s WACC in parts b) and c)? (Do not round intermediate calculations and enter your answers as a percent rounded to the nearest whole number, e.g., 32.)

Answer 1

WACC, the weighted average cost of capital is given by = w(e)*r(e) + w(d)*r(d)*(1-t)

where w(e) is the weight of equity in the capital structure

w(d) is the weight of debt in the capital structure

r(e) is the return on equity

r(d) is the return on debt

t is the tax-rate = 0

Cost of equity = Cost of equity when debt is 0 + ( Cost of equity when debt is 0 -cost of debt)*(D/E)

D/E is the ratio of debt:equity

a) Since the firm has no debt

WACC = cost of equity = 13%

b) Cost of equity = 13% + (13%-7%)*(0.3/0.7) = 12.14%

c) Cost of equity = 13% + (13%-7%)*(0.45/0.55) = 11.36%

d) WACC =w(e)*r(e) + w(d)*r(d)

WACC in part b = (12.14% *0.7) + (7%*0.3) = 10.60%

WACC in part b = (11.36% *0.55) + (7%*0.45) = 9.40%