Question

quity cost of capital is 9%, and its debt cost of capital is 5%. a. What is Rumolt's pre-tax WACC? b. If Rumolt's corporate tax rate is 40%, what is its after-tax WACC? NatNah, a builder of acoustic accessories, has no debt and an equity cost of capital of 14%. Suppose NatNah decides to increase its leverage to maintain a market debt-to-value ratio of 0.5. Suppose its debt cost of capital is 9% and its corporate tax rate is 35%. If NatNah's pre-tax WACC remains constant, what will be its (effective after-tax) WACC with the increase in leverage?

Answer 1

a. Rumolt's pre-tax WACC is 9%. b. Rumolt's after-tax WACC is 9%. c. NatNah's effective after-tax WACC after increasing leverage is 11.3%.

Step-by-step explanation:

a. To calculate Rumolt's pre-tax WACC, we need to use the formula: WACC = (E/V) * Re + (D/V) * Rd. Given that the equity cost of capital is 9% and the debt cost of capital is 5%, and assuming that the firm's capital structure consists of 100% equity, we have: WACC = (1/1) * 9% + (0/1) * 5% = 9%.

b. To calculate Rumolt's after-tax WACC, we need to use the formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tax Rate). Given that the corporate tax rate is 40%, the after-tax WACC would be: WACC = (1/1) * 9% + (0/1) * 5% * (1 - 40%) = 9%.

With the increase in leverage, NatNah's WACC will change. To calculate the new WACC, we need to use the formula: WACC = [(E/V) * Re] + [(D/V) * Rd * (1 - Tax Rate)]. Since NatNah is increasing its leverage to maintain a market debt-to-value ratio of 0.5, the capital structure will consist of 50% debt and 50% equity. The new WACC would be: WACC = (0.5/1) * 14% + (0.5/1) * 9% * (1 - 35%) = 11.3%.