Martin is considering reducing it debt load and is contemplating a 20% debt and

Question

Martin is considering reducing it debt load and is contemplating a 20% debt and 80% common equity mix. If they do this, what should happen to the cost of debt (not the weighted cost but the cost of each component)? The cost of equity (not the weighted cost)? Why?

Assume that the restructuring is completed and Martin is now 20% debt and 80% common equity. The after tax cost of debt is 8% and the cost of common equity is 10%. What is Martins new weighted average cost of capital?

Should Martin make the capital structure change mentioned in the prior problem?

Instead, assume that the restructuring is completed and Martin is now 20% debt and 80% common equity. But the after tax cost of debt is 9% and the cost of common equity is 13.5%. What is Martins new weighted average cost of capital?

Now, should Martin make the capital structure change mentioned in the prior problem?

Explanation / Answer

Case 1:

WACC = weight of debt*cost of debt+weight of equity*cost of equity

=20%*8%+80%*10%

=9.6%

Case 2:

WACC = weight of debt*cost of debt+weight of equity*cost of equity

=20%*9%+80%*13.5%

=12.6%

Martin should not make the capital structure change mentioned in the prior problem as the cost of capital is increasing

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