You desire the lowest WACC for your business. You determine that as the amount o

Question

You desire the lowest WACC for your business. You determine that as the amount of debt rises, the cost of debt and equity will rise. Which option below is the one you will pursue if the tax rate is 25%?

A:        D/(D+E) = 10%                        Before tax cost of debt = 4%    Cost of equity =            8.0%   

B:         D/(D+E) = 25%                        Before tax cost of debt = 5%    Cost of equity =            8.5%

C:         D/(D+E) = 50%                        Before tax cost of debt = 6%    Cost of equity =            10.0%

D:        D/(D+E) = 75%                        Before tax cost of debt = 9%    Cost of equity =            12.0%

Explanation / Answer

WACC

effective cost of debt is 1 - tax rate = 1- 0.25 = 0.75

A -> 0.1 * 0.75 * 4 + 0.9 * 8 = 7.5%

B -> 0.25 * 0.75 * 5 + 0.75 * 8.5 = 7.3125%

C -> 0.5 * 0.75 * 6 + 0.5 * 10 = 7.25%

D -> 0.75 * 0.75 * 9 + 0.25 * 12 = 8.0625%

Hence C has the least WACC

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