General Forge and Foundry Corporation currently has no debt in its capital struc
ID: 2792117 • Letter: G
Question
General Forge and Foundry Corporation currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.05, and its cost of equity is 12.43%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 12.43%. The risk-free rate of interest (FRF) is 3.5%, and the market risk premium (RP) is 8.5% General Forge's marginal tax rate is 35%. General Forge is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table. Before-Tax Cost of Debt (rd) Levered Beta (b) 1.05 Cost of Equity (rs) 12.43% 13.87% 16.34% D/A E/A Ratio Ratio D/E Ratio Rating Bond WACC 12.43% 12.03% 0.0 0.2 0.4 0.6 0.8 1.0 0.8 0.6 0.4 0.2 0.00 0.25 0.67 1.50 7.7% 8.9% 11.9% 1.51 2.07 3.78 11.91% 35.63%Explanation / Answer
Case A:
Weight of Debt, D = 0.2
Weight of Equity, E = 0.8
Unlevered Beta, bU = 1.05
tax rate = 35%
Levered Beta, bL = bU * [1 + (1-tax) * (D/E)]
Levered Beta, bL = 1.05 * [1 + (1-0.35)*(0.2/0.8)]
Levered Beta, bL = 1.05 * 1.1625
Levered Beta, bL = 1.22
Case B:
Before-tax Cost of Debt, rd = 7.7%
Cost of Equity, rs = 16.34%
Weight of Debt, D = 0.4
Weight of Equity, E = 0.6
WACC = D * rd * (1-tax) + E * rs
WACC = 0.40 * 7.7% * (1-0.35) + 0.60 * 16.34%
WACC = 11.81%
Case C:
Risk-free rate, rRF = 3.5%
Market risk premium, RP = 8.50%
Levered beta, bL = 2.07
Cost of Equity = rRF + bL * RP
Cost of Equity = 3.50% + 2.07 * 8.50%
Cost of Equity = 21.10%
Case D:
Weight of Debt, D = 0.80
Weight of Equity, E = 0.20
D/E Ratio = D / E
D/E Ratio = 0.80 / 0.20
D/E Ratio = 4.00
Before-tax Cost of Debt, rd = 11.9%
Cost of Equity, rs = 35.63%
Weight of Debt, D = 0.8
Weight of Equity, E = 0.2
WACC = D * rd * (1-tax) + E * rs
WACC = 0.80 * 11.90% * (1-0.35) + 0.20 * 35.63%
WACC = 13.31%
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.