Question

NatNah, a builder of acoustic accessories, has no debt and an equity cost of capital of 13%. Suppose NatNah decides to increase its leverage to maintain a market debt-to-value ratio of 0.5. Suppose its debt cost of capital is 8% and its corporate tax rate is 35%. If Natah's pre-tax WACC remains constant, what will be its (effective after-tax) WACC with the increase in leverage? The effective after-tax WACC will be %. (Round to two decimal places.)

Answer 1

For this, we'd use the MM Proposition II With tax. which is :-

R_e = R_o + (R₀ - R_D) (1-t) D/E

Where R_e the new cost of capital considering the effect of debt, which we have to calculate, and R₀ is the Cost of capital without debt, R_D is the cost of debt and D/E is debt to equity ratio.

Debt to value is debt/Total capital, that means debt is 50% of total capital hence the other 50% is equity, and the D/E Ratio is 1.

R_o = 13%

R_D = 8%

(1-t) = (1-0.35) = 0.65

Putting everything in the formula above.

= 13% + (13-8)(0.65)(1)

= 16.25%

Hence the new effective after tax wacc is 16.25%.