Acetate Inc. has equity with a market value of $25 million and debt with a marke

Question

Acetate Inc. has equity with a market value of $25 million and debt with a market value of $10 million.  The firm's weighted average cost of captial is 15.8% and its pretax cost of debt is 10%.  The firm is subject to a corporate tax rate of 35%.  Assume no other imperfections in the financial market.

a.  What is Acetate's cost of equity?

b. What is the cost of captial for an otherwise identical all-equity firm?

c. What would Acetate's weighted average cost of captial be if the firm borrows additional $5 million and uses the proceeds to repurchases shares?

Explanation / Answer

let cost of equity be C(r)

then wacc = (E/(D+E)) *C(r) +(D/(D+E))*0.1*(1-0.35)

=> 0.158 = (25/35)*c(r) + 10/35 *0.065

=> c(r) = 0.1952 = 19.52%

b) for an otherwise identical all-equity firm

let cost of capital be RUL

RE = RUL + [D/E] [RUL

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