Question

Capital Structure, the cost of capital, and stock price WACC = Wd (ra) (1-T) + W. (rs) TE 0.40 0.06 0.10 Capital Structure (Debt/Assets = Wd) DIE Beta WACC Value 10% 1.60 0.2500 30% 40% 8.0% 8.3% 9.0% 10.0% 12.0% 1.0000

Answer 1

Following is the completed table:

Wd	rd	D/E	Beta	Rs	WACC
0.00%	0.00%	0.00%	1.6	6%+1.6(10%-6%)=12.40%	12.40%
10.00%	8.00%	11.11%	1.6	6%+1.6(10%-6%)=12.40%	11.64%
20.00%	8.30%	25.00%	1.6	6%+1.6(10%-6%)=12.40%	10.92%
30.00%	9.00%	42.86%	1.6	6%+1.6(10%-6%)=12.40%	10.30%
40.00%	10.00%	66.67%	1.6	6%+1.6(10%-6%)=12.40%	9.84%
50.00%	12.00%	100.00%	1.6	6%+1.6(10%-6%)=12.40%	9.80%

• Beta remains constant for all levels of equity
• 
  R; = R + B(Rm – R)
  
• WACC is calculated by the given formula
• 
  Debt + Equity = Assets
  
• So if D/E = 0.25, then debt = 0.25 and equity = 1 so assets = 1.25 therefore Wd = 0.25/1.25 = 20%
• So if D/E = 1, then debt = 1 and equity = 1 so assets = 2 therefore Wd = 1/2 = 50%
• If Wd = 10% then We = 90% so D/E = 10/90 = 11.11 and so on