Shadow Corp. has no debt but can borrow at 8 percent. The firm’s WACC is current
ID: 2795737 • Letter: S
Question
Shadow Corp. has no debt but can borrow at 8 percent. The firm’s WACC is currently 9.8 percent, and the tax rate is 35 percent. a. What is Shadow’s cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) Cost of equity % b. If the firm converts to 15 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) c. If the firm converts to 50 percent debt, what will its cost of equity be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) d-1 If the firm converts to 15 percent debt, what will the company's WACC be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).) d-2 If the firm converts to 50 percent debt, what will the company's WACC be? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)
Explanation / Answer
Answer a.
As Shadow Corp has no debt ie Wd=0 and thus weight of equity We = 1-Wd = 1-0 = 1
WACC = 9.8%, and cost of debt = Kd = 8%*(1-0.35) = 0.08*0.65 = 0.052 = 5.2%
WACC = We*Ke + Wd*kd
9.8% = 1*Ke + 0*5.2
1Ke = 9.8%
Ke = 9.8%
Hence Shadow's cost of equity = 9.8%
Answer b.
If firm turns to 15% debt = Wd = 0.15 and We = 1-Wd = 1-0.15 = 0.85
WACC = We*Ke + Wd*kd
9.8% = 0.85*Ke + 0.15*5.2
9.8 = 0.85Ke + 0.78
9.8 - 0.78 = 0.85Ke
9.02 = 0.85Ke
Ke = 9.02/0.85
Ke = 10.612%
Hence Shadow's cost of equity = 10.612% (when firm converts to 15% debt)
Answer c.
If firm turns to 50% debt = Wd = 0.5 and We = 1-Wd = 1-0.5 = 0.5
WACC = We*Ke + Wd*kd
9.8% = 0.5*Ke + 0.5*5.2
9.8 = 0.5Ke + 2.6
9.8 - 2.6 = 0.5Ke
7.2 = 0.5Ke
Ke = 7.2/0.5
Ke = 14.4%
Hence Shadow's cost of equity = 14.40% (when firm converts to 50% debt)
Answer d-1.
If the firm converts to 15 percent debt, what will the company's WACC wil be 9.8% (as debt and equity cost of capital adjust itself to WACC in this question)
Answer d-2.
If the firm converts to 50 percent debt, what will the company's WACC wil be 9.8% (as debt and equity cost of capital adjust itself to WACC in this question)
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