Question

Company XYZ has a target capital structure of 50% equity and 50% debt. Its cost of equity is 6%, and cost of debt is 8% What would happen to XYZ's WACC if its capital structure were to shift to 75% equity and 25% debt? Assume a tax rate is40%.
A. WACC decrease
B. WACC increases
C. WACC remains constant

Answer 1

Answer:

Option (B) is correct.

Explanation:

WACC = (We × ke) + [Wd × kd × (1 - t)]

where,

We = Equity

Wd = Debt

ke = cost of equity

kd = cost of debt

t = tax rate

At 50% equity and 50% debt,

WACC = (50% × 6%) + [50% × 8% × (1 - 0.4)]

           = 5.40%

At 75% equity and 25% debt,

WACC = (75% × 6%) + [25% × 8% × (1 - 0.4)]

           = 5.70%

Therefore, there is an increase in the XYZ's WACC if its capital structure were to shift to 75% equity and 25% debt.