General Forge and Foundry Corporation currently has no debt in its capital struc

Question

General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.2, and its cost of equity is 14.20%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 14.20%. The risk-free rate of interest (r) is 4%, and the market risk premium (RP) is 8.5%. General Forge's marginal tax rate is 30%. General Forge is examining how different levels of debt will affect ts costs of debt and equity, as well s its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table D/A E/A Ratio Ratio D/E Ratio Rating Before-Tax Cost of Debt (ra) Bond LeveredCost of Beta (b) Equity (rs) WACC 14.20% 14.20% 8.496 | ) is.99% 13.97% 1.2 0.0 1.0 0.2 0.8 0.4 0.6 0.6 0.4 1.50 BB 11.1% 2.46 -14.63% 0.8 0.2 ? 14.3% , 4.56 0.00 0.25 0.67 BBB 8.9% 1.76 18.96%

Explanation / Answer

Case 1:

Levered Beta = Unlevered Beta * [1 + (1 - tax)*(D/E)]
Levered Beta = 1.2 * [1 + (1-0.30)*0.25]
Levered Beta = 1.2 * 1.175
Levered Beta = 1.41

Case 2:

WACC = (D/A)*Before-tax Cost of Debt*(1-tax) + (E/A)*Cost of Equity
WACC = 0.40*8.90%*(1-0.30) + 0.60*18.96%
WACC = 13.87%

Case 3:

WACC = (D/A)*Before-tax Cost of Debt*(1-tax) + (E/A)*Cost of Equity
0.1463 = 0.60*0.111*(1-0.30) + 0.40*rs
0.1463 = 0.04662 + 0.40*rs
0.09968 = 0.40*rs
rs = 0.2492
rs = 24.92%

Cost of Equity = 24.92%

Case 4:

D/E Ratio = (D/A) / (E/A)
D/E Ratio = 0.8 / 0.2
D/E Ratio = 4.00

WACC = (D/A)*Before-tax Cost of Debt*(1-tax) + (E/A)*Cost of Equity
WACC = 0.80*14.30%*(1-0.30) + 0.20*42.76%
WACC = 16.56%

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