A company currently has a WACC of 10.6 percent and no debt. The tax rate is 21 percent. a. What is the company's current cost of equity? b. If the firm converts to 20 percent debt with interest rate 5%, what will its cost of equity be? And the WACC? C. If the firm converts to 80 percent debt with interest rate 5%, what will its cost of equity be? And the WACC? d. What can you conclude from the values of the cost of equity and WACC obtained in b. and c.?

a) When the company has no debt and its WACC is 10.6%, assuming no preference stock in the capital structure, the current cost of equity of the company is 10.6%

b)

c)

d)

Introduction of Debt into the capital structure would definitely affect the cost of equity since Equity holders are required to bear more risk now. However, due to absence of information on beta of Equity, it is assumed that cost of equity doesn't change with the inclusion of debt into the capital structure

It can be seen that the company has access to low-cost debt @ 3.95% after tax (i.e. 5*(1-0.21)). With the inclusion of low-cost debt to the capital structure, the WACC reduces to 9.27% from 10.6% in Option B and to 5.28% in Option C.