U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. I

Question

U.S. Robotics Inc. has a current capital structure of 30% debt and 70% equity. Its current before-tax cost of debt is 6%, and its tax rate is 45%. It currently has a levered beta of 1.15. The risk-free rate is 3%, and the risk premium on the market is 8%. U.S. Robotics Inc. is considering changing its capital structure to 60% debt and 40% equity. Increasing the firm's level of debt will cause its before-tax cost of debt to increase to 8%. First, solve for U.S. Robotics Inc.'s unlevered beta. Relever U.S. Robotics Inc.'s beta using the firm's new capital structure. Use U.S. Robotics Inc.'s levered beta under the new capital structure, to solve for its cost of equity under the new capital structure. What will the firm's weighted average cost of capital (WACC) be if it makes this change in its capital structure?

Explanation / Answer

Cost of debt is 6.00% Post tax cost of debt 3.30% % of debt 30% Livered beta 1.15 Beta Unlivered = beta livered/(1+(1-tax)*(debt/equity)) 0.930635838 Relivering as below Beta livered = beta unlivered*(1+(1-tax)*(debt/equity)) 1.698410405 Using CAPM cost of equity is Rf +beta*Rm 16.59% Cost of debt is 8% Post tax cost of debt 4.40% % of equity 40% % of debt 60% WACC is cost of equity*% of Equity + cost of debt*% of debt   9.3% Option 4

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