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

Let us first of all recall the formula to calculate WACC, which is as follows:-

WACC = [Weight of Equity * Cost of equity] + [Weight of Preferred Equity * Cost of Preferred Equity] + [Weight of debt * Cost of debt (1 – Tax rate)]

Now, let us solve each of the above problems using the formula.

1) We need to calculate the cost of equity and we are provided with the information that: The cost of debt is 6.7% and there is no debt in the capital structure and there is 100% equity; the WACC is 8.5% and the tax rate is 35%.

Solving for cost of equity using the above formula we have:

8.5% = [1 * Cost of equity] + [0 * 6.7%(1 – 0.35)]

So, the cost of equity is 8.5%.

2) Similarly, solving for the cost of equity when we have 20% debt in the capital structure we have the cost of equity as follows:-

8.5% = [80% * Cost of equity] + [20% * 6.7%(1 – 35%]

8.5% = [80% * Cost of equity] + [0.87%]

8.5% – 0.87% = [80% * Cost of equity]

Cost of equity = 9.54%

Cost of equity when we have 20% debt in capital structure is: 9.54%

3) Similarly, solving for the cost of equity when we have 40% debt in the capital structure we have the cost of equity as follows:-

8.5% = [60% * Cost of equity] + [40% * 6.7%(1 – 35%]

8.5% = [60% * Cost of equity] + [1.74%]

8.5% – 1.74% = [60% * Cost of equity]

Cost of equity = 11.27%

Cost of equity when we have 40% debt in capital structure is: 11.27%

4) Solving for WACC when we have 20% debt:

WACC: [80% * 9.54%] + [20% * 6.7%(1 – 35%]

WACC = 8.5%

(The value of cost of equity used is the value we calculated before)

5) Solving for WACC when we have 40% debt:

WACC: [60% * 11.27%] + [40% * 6.7%(1 – 35%]

WACC = 8.5%

(The value of cost of equity used is the value we calculated before)

I hope my solution solves your query.

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