Shadow Corp. has no debt but can borrow at 7.6 percent. The firm’s WACC is curre

Question

Shadow Corp. has no debt but can borrow at 7.6 percent. The firm’s WACC is currently 9.4 percent, and the tax rate is 35 percent.

a. What is Shadow’s cost of equity? (Do not round intermediate calculations.)

b. If the firm converts to 25 percent debt, what will its cost of equity be? (Do not round intermediate calculations and round your final answer to 2 decimal places.

c. If the firm converts to 50 percent debt, what will its cost of equity be? (Do not round intermediate calculations and round your final answer to 2 decimal places.

d-1 If the firm converts to 25 percent debt, what will the company's WACC be? (Do not round intermediate calculations and round your final answer to 2 decimal places.

d-2 If the firm converts to 50 percent debt, what will the company's WACC be? (Do not round intermediate calculations and round your final answer to 2 decimal places.

Explanation / Answer

Part a)

Since there is no debt, the WACC is calculated using cost of equity only. Therefore, cost of equity would be equal to WACC.

Cost of Equity= 9.40%

Part b)

rE= WACC + (WACC-rD) x D/E

    = 0.094 + (0.094 -0.076) x 0.25/0.75

    = 0.094 + 0.006

    = 10%

Part c)

rE= WACC + (WACC-rD) x D/E

    = 0.094 + (0.094 -0.076) x 0.50/0.50

    = 0.094 + 0.018

    = 11.20%

Part d-1)

MM hypothesis proposes that capital structure decision is irrelevant for the value of the firm thus it does not affect WACC. So WACC will be 9.40%.

Part d-2)

MM hypothesis proposes that capital structure decision is irrelevant for the value of the firm thus it does not affect WACC. So WACC will be 9.40%.

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