Final answer:
A. The company's cost of equity is 5.85%. B. If the company converts to 25% debt, the cost of equity will be 7.225% and the new WACC will be 5.45%. C. If the company converts to 50% debt, the cost of equity will be 8.6% and the new WACC will be 5.675%.
Step-by-step explanation:
A. Calculation of Cost of Equity
The formula to calculate the cost of equity is:
Cost of Equity = Cost of Debt + Equity Risk Premium
Since the given company's WACC is 11.35% and the cost of debt is 5.5%, we can calculate the equity risk premium as follows:
Equity Risk Premium = WACC - Cost of Debt
Equity Risk Premium = 11.35% - 5.5% = 5.85%
Therefore, the company's cost of equity is 5.85%.
B. Conversion to 25% Debt
When the company converts to 25% debt, the new cost of debt will be 25% of 5.5% = 1.375%.
To calculate the new cost of equity, we can use the formula:
New Cost of Equity = Cost of Debt + Equity Risk Premium
New Cost of Equity = 1.375% + 5.85% = 7.225%
The new WACC can be calculated as:
New WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
New WACC = (25% * 1.375%) + (75% * 7.225%) = 5.45%
C. Conversion to 50% Debt
When the company converts to 50% debt, the new cost of debt will be 50% of 5.5% = 2.75%.
The new cost of equity can be calculated as:
New Cost of Equity = Cost of Debt + Equity Risk Premium
New Cost of Equity = 2.75% + 5.85% = 8.6%
The new WACC can be calculated as:
New WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
New WACC = (50% * 2.75%) + (50% * 8.6%) = 5.675%