20. Evans technology has following capital structure. DEBT…………………………………………………………
ID: 2774614 • Letter: 2
Question
20. Evans technology has following capital structure. DEBT…………………………………………………………………………………………40% Common equity………………………………………………………………………………60
The after tax cost of debt is 6 percent, and the cost of common equity (in the form of retained earnings) is 13 percent.
a. What is the firm’s weighted average cost of capital?
b. An outside consultant has suggested that because debt is cheaper than equity, the firm should switch to a capital structure that is 50 percent debt and 50 percent equity. Under this new and more debt-oriented arrangement, the after tax cost of debt is 7 percent, and the cost of common equity (in the form of retained earnings) is 15 percent. Recalculate the firm’s weighted average cost of capital.
c. Which plan is optimal in terms of minimizing the weighted average cost of capital?
Explanation / Answer
WACC in case 1 = %age of debt * after tax cost of debt + %age of equity * cost of equity
= .4* 6 + .6 *13 = 10.2%
WACC in case 2 = .5 * 7 + .5 * 15 = 11%
First plan is better is WACC is lower in plan 1 (10.2) compared to plan 2 (11)
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