A firm has zero debt in its capital structure. Its overall
cost of capital is currently 9%. The firm is considering a new capital structure with 40% debt. The interest rate of the debt would be 4% no matter what amount of debt is taken on.
a. Assuming that the corporate tax rate is 34%, what would be the firm’s cost of equity and WACC with the new capital structure?
b. Now increase the new capital structure to a D/E ratio of 2.333333. What would the cost of equity be now? What about the WACC?
c. Why does the cost of equity and the WACC change, if at all, from part (a) to part (b)?
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