Company ABC has the following (stylized) balance sheet, in million $. Current Assets 40 Debt: 75 Plant and Equipment 85 Equity 50 Total Assets 125 Firm Value 125 The opportunity cost of capital of investing in ABC's assets is given by r = 15%. Costs of debt are given by rD = 7%. The corporate tax rate (TC) is equal to 35%.
a. Determine the cost of equity ( rE) and the (‘after tax') weighted average cost of capital (WACC) of the firm. The company considers replacing $25 million of equity by long term debt. Because of increased leverage, the cost of debt is set to 8%.
b. Compute the WACC under this new capital structure.
c. Make a sketch of WACC as function of leverage (D/E) that is in line with the given information.
d. Analysts estimate that the new financial structure will cause an increase of costs of financial distress, and that the cost of capital will increase correspondingly to 16%. Is the new capital structure an improvement according to the trade-off theory?