Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the c

Question

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

True or False?

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

True or False?

Explanation / Answer

Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

WACC is calculated with the help of formula :

WACC = (Cost of Equity * weight of Equity) + (Cost of Debt * Weight of Debt )

In the given case the cost of Debt is less than cost of equity, so If the weight of debt shall increase, the weighted average cost of capital shall decrease. Hence the given statement is TRUE.

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