Question

Roscoe's Pet Groomers Inc. currently offers equity investors a return on their equity of 12.0%. The firm uses an Optimal Capital Structure approach and for the past 5 years their D/E ratio has been 1.0. Their cash flow has improved and times interest earned has increased steadily. Their CFO, Mr. Charles has decided that they should increase their D/E to 1.5. Currently their debt carries a 7% yield and has an interest rate variability covenant which would make the rates change to 11% if the firm alters their capital structure, and their tax rate is 21%. Their Profit Margin (6%) and Total Asset Turnover (1.0) will remain constant. What will be the impact on their WACC with the change in capital structure? Increase of 1.75% Increase of 3.64% Increase of 5.51% Increase of 1.24%

Answer 1

Increase of 1.24%

Before the D/E increase

Weight of equity = Weight of debt = 1/2 = 0.5

WACC=after tax cost of debt*W(D)+cost of equity*W(E)
WACC=0.5*0.07*(1-0.21)+0.12*0.5
WACC =8.765%

After the D/E increase

Weight of debt = 1.5/(1+1.5) = 0.6

Weight of equity = 1-0.6 = 0.4

WACC=after tax cost of debt*W(D)+cost of equity*W(E)
WACC=0.6*0.11*(1-0.21)+0.12*0.4
WACC =10.014%

Increase in WACC = (10.014-8.765)% = 1.24%