Question

answer second part of question below

A firm currently has a debt-equity ratio of 0.4. The debt, which is virtually riskless, pays an interest rate of 5%. The expected rate of return on the equity is 10 %. What is the Weighted Average Cost of Capital if the firm pays no taxes? Enter your answer as a percentage rounded to two decimal places. Do not include the percentage sign in your answer. WACC = 8.57 Correct response: 8.57+0.02 What would happen to the expected rate of return on equity if the firm changed its debt-equity ratio to 0.2? Assume the firm pays no taxes, the cost of debt does not change, and that the original WACC is 8.57 %. Enter your answer as a percentage rounded to two decimal places. Do not include percentage sign as part of your answer. Return on Equity = Number

Answer 1

Solution to the SECOND PART

Expected return on equity

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

8.57% = [5.00% x (0.20/1.20)] + [Cost of equity x (1 / 1.20)]

8.57% = [5.00% x 0.1667] + [Cost of equity x 0.8333]

8.57% - 0.83% = Cost of equity x 0.8333

7.74% = Cost of equity x 0.8333

Cost of equity = 7.74% / 0.8333

Cost of equity = 9.28%

“Hence, the Expected return on equity will be 9.28%”

NOTE

Weight of Debt = Debt-to-equity ratio / (1 + Debt-to-equity ratio)

Weight of Equity = 1 / (1 + Debt-to-equity ratio)