Question

Assume that Modigliani and Miller’s perfect capital markets assumptions hold and there are no corporate taxes. A company’s cost of debt is 10%, its cost of equity is 25% and its debt-to-equity ratio is 25%.

Calculate the company’s weighted average cost of capital.Show your calculations.

How would the cost of equity change if the company’s debt-to-equity ratio rises to 50%? Show your calculations.

Answer 1

Debt Equity Ratio = Debt / Equity

0.25 = Debt / Equity

0.25 Equity = Debt

This Means that Firm has Equity and debt in proportion to 4:1

WACC = Cost of equity * ( Equity / Total Value ) + Cost of debt * ( Equity / Total Value)

A) WACC = 25% * ( 4/5) + 10% * ( 1/5)

= 20% + 2%

= 22%

B) When debt -equity ratio is 50%

Then It means equity and debt proportion is 2 and 1.

So, WACC = 25% * ( 2/3) + 10% * ( 1/3)

= 16.667% + 3.3333%

= 20%