Firm A's capital structure contains 20 percent debt and 80 percent equity. Firm B's capital structure contains 50 percent debt and 50 percent equity.
Both firms pay 7 percent annual interest on their debt. The stock of Firm A has a beta of 1.0, and the stock of Firm B has a beta of 1.375. The risk-free rate of interest equals 4 percent, and the expected return on the market portfolio equals 12 percent.
a. Calculate the WACC for each firm, assuming there are no taxes.
b. Recalculate the WACC figures, assuming that the firms face a marginal tax rate of 34 percent.
c. Explain how taking taxes into account in part (b) changes your answer found in part (a).