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I have this difficult problem I can't seem to solve. Can someone please help me?

5. Blue Co. has a weighted average cost of capital (WACC) of 14% at a debt-to-value ratio of 30%. The current return on equity is 18% and the corporate tax rate is 21%. Assume Blue keeps a constant debt-to-equity ratio.
What is the required return on debt?

Answer: 5.91 %

6. Consider the information in question 5, but now assume that the interest rate paid by Blue is 8%. Blue decides to increase the debt level. After the debt issuance, the company changes its capital structure policy moving from a constant debt-to-equity ratio policy to a constant debt policy. Also, after new debt is issued, the debt-to-value ratio is 50%.

What is now the WACC for Blue?

The answer should be 13.4 %, but I don't understand how to find it.

Comments (7)

  • Cowfoot's picture

    .

    The business of business is business.

  • shark-monkey's picture

    Where is this question from?

    Fear is the greatest motivator. Motivation is what it takes to find profit.

  • Ovechkin08's picture

    Well, you've added debt to the capital structure which, according to MM proposition 2 makes the equity more risky, meaning that the cost of equity should increase.

  • lasampdoria's picture

    5.

    14% = 30%*(1-21%)*Kd+70%*18%

    Kd= 5.907%

    6.

    WACC = 50%*(1-21%)*.8%+50%*Ke

    Ke is NOT 18%. Why? As you lever up, your Beta increases, increasing your cost of equity (all other input remaining equal).

    By doing simply math, we can see Ke is 20.48%.

    Hope this helped.

    "Those who can give up essential liberty to obtain a little temporary safety, deserve neither liberty nor safety."- Benjamin Franklin

  • BustedLoser's picture

    Thank you for your replies.

    @lasampdoria. The answer is not given, and so the WACC equation has two unknowns, both the Ke and WACC.

    How would I go about calculating the new cost of equity without knowing the WACC?

    shark-monkey wrote:
    Where is this question from?

    These questions are from an earlier exam in corporate finance at my school, Sir.

  • BustedLoser's picture

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  • In reply to BustedLoser
    lasampdoria's picture

    "Those who can give up essential liberty to obtain a little temporary safety, deserve neither liberty nor safety."- Benjamin Franklin