General Forge and Foundry Corporation currendy has no debt in its capital struct

Question

General Forge and Foundry Corporation currendy 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 11.40%. Because the firm has no debt in its capital st cture, its weighted average oost of capital (WACC) also equals 11.40%. The risk-free rate of interest (ne) is 3%, and the market risk premium (RP) is 8%. 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 D/A EA Bond Ratio Ratio D/E Ratio Rating Levered Beta (b) 1.05 Cost of Equity (rs) 11.40% 12.76% 15.08% WACC 11.40% 11.26% 0.0 0.2 1.0 0.8 0.6 0.4 0.2 0.00 0.25 0.67 1.50 8.1% 8.5% 10.9% 13.9% 1.51 0.6 0.8 2.07 3.78 ] 12 12.08% 33.24%

Explanation / Answer

WACC=D/A*before tax cost of debt*(1-tax rate)+E/A*cost of equity
D/E=(D/A)/(E/A)
Cost of equity=risk free+beta*market risk premium
Hence,
D/A=0.2: cost of equity=12.76%
Hence,levered beta=(12.76%-3%)/8%=1.22

D/A=0.4: WACC=0.4*8.5%*(1-35%)+0.6*15.08%=11.258%

D/A=0.6: Cost of equity=3%+2.07*8%=19.56%

D/A=0.8: D/E=0.8/0.2=4
WACC=0.8*13.9%*(1-35%)+0.2*33.24%=13.876%

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