Question

Navarro corporation has no debt but can borrow at 6.7 percent. the firm’s wacc is currently 8.9 percent and the tax rate is 25 percent. assume mm theory. (a) what is the company’s cost of equity? (b) if the firm converts to 40 percent debt, what will its cost of equity be? (c) if the firm converts to 65 percent debt, what will its cost of equity be? (d) if the firm converts to 40 percent debt, what is the company’s wacc? (e) if the firm converts to 65 percent debt, what is the company’s wacc?

Answer 1

The company's cost of equity is 8.9%. With 40% debt, the cost of equity is 6.81%. With 65% debt, the cost of equity is 4.925%. With 40% debt, the company's WACC is 4.086%, and with 65% debt, the WACC is 5.3875%.

Step-by-step explanation:

To find the company's cost of equity, we can use the formula:

Cost of Equity = WACC - (Weight of Debt x Cost of Debt)

Since Navarro Corporation has no debt, the weight of debt is 0. Therefore, the cost of equity is equal to the company's WACC, which is 8.9 percent.

Now, let's calculate the cost of equity when the firm converts to 40 percent debt and 65 percent debt. Assuming that the cost of debt remains at 6.7 percent:

(b) Cost of Equity with 40% Debt:

Cost of Equity = WACC - (Weight of Debt x Cost of Debt)

Weight of Debt = 40%, Cost of Debt = 6.7%

Cost of Equity = 8.9% - (0.4 x 6.7%) = 6.81%

(c) Cost of Equity with 65% Debt:

Weight of Debt = 65%, Cost of Debt = 6.7%

Cost of Equity = 8.9% - (0.65 x 6.7%) = 4.925%

Next, let's calculate the company's WACC when the firm converts to 40 percent debt and 65 percent debt:

(d) WACC with 40% Debt:

WACC = (Weight of Equity x Cost of Equity) + (Weight of Debt x Cost of Debt)

Weight of Equity = 60%, Cost of Equity = 6.81%

Weight of Debt = 40%, Cost of Debt = 6.7%

WACC = (0.6 x 6.81%) + (0.4 x 6.7%) = 4.086%

(e) WACC with 65% Debt:

Weight of Equity = 35%, Cost of Equity = 4.925%

Weight of Debt = 65%, Cost of Debt = 6.7%

WACC = (0.35 x 4.925%) + (0.65 x 6.7%) = 5.3875%