Suppose that a TV manufacturing company is currently financed with 30% debt and 70% equity (at market values). The required return on equity is 15%, and the required return on debt is 5%. For all parts of this question, assume that the Modigliani-Miller theorem holds (i.e., there are no frictions such as taxes, costs of financial distress, asymmetric information, etc.).

(a) What is the company’s weighted-average cost of capital?

(b) The company decides to raise additional funds by issuing some more debt. After doing so, its capital structure changes to 40% debt and 60% equity. Assume, for now, that the issue is sufficiently small to not change the cost of debt (which therefore continues to be 5%). What is the company’s weighted-average cost of capital after the debt issuance? What is the required return on the company’s equity? 

(c) Assume now that the capital structure change described in part (b) did raise the cost of debt after all, from 5% to 6%. What is the company’s weighted-average cost of capital after the debt issuance, given that the cost of debt has risen to 6%? What is the required return on the company’s equity?

Answer rating: 100% (QA)

a Weighted Average Cost of Capital WACC before debt issuance We can use the following formula to cal... View the full answer