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

1. 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 %

1. 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)

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The business of business is business.

Where is this question from?

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

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.

Best Response
1. 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

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:

Where is this question from?

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

Eureka, lol. Think I've got it now, so as leverage increase the risk of equity also goes up and hence the cost of equity.

So if Rs is the cost of levered equity, Ru is the cost of unlevered equity, Rb is the cost of borrowing, tc the corporate tax rate, then

Rs = R0 + (R0-Rb) * B/S (1-tc)

I can use the information from question 5, solve for R0, then use that to calculate the new cost of levered equity and then calculate the average cost of capital. Brilliant! :)

Hold your horses, Wall Street, here I come, lol.

Thank you very much to all of you for helping me.

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