Shadow Corp. has no debt but can borrow at 6.7 percent. The firm’s WACC is curre

Question

Shadow Corp. has no debt but can borrow at 6.7 percent. The firm’s WACC is currently 8.5 percent, and the tax rate is 35 percent.

What is Shadow’s cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

If the firm converts to 20 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

If the firm converts to 40 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

If the firm converts to 20 percent debt, what will the company's WACC be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

If the firm converts to 40 percent debt, what will the company's WACC be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

What is Shadow’s cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

a) As the firm has no debt (unlevered firm) WACC = Ke (cost of equity).

   Therefore, Cost of Equity Ke = 8.50%

b) Here we can use the formula Ke = Ku + (D(1-t)/V) * (Ku - Kd)

   where Ku is the cost of capital of unlevered firm(cost of ungeared equity), D is the debt amount, V is the value of the firm and t the tax rate.

substituting values we have = Ke = 8.5 + 0.2*0.65*1.8 = 8.73%

c) Using the formula at (3) above we have for 40% debt.

Ke = 8.5 + 0.4*0.65*1.8 = 8.97%

d) WACC for 20% debt:

   = 8.5*0.8 + 8.73*.65*0.2 = 7.93%.

e) WACC FOR 40% debt:

= 8.5*.6 + 8.97*.65*.4 = 7.46%.

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