Shadow Corp. has no debt but can borrow at 7%. The firm’s WACC is currently 11%, and the tax rate is 35%.
a. What is Shadow’s cost of equity?
b. If the firm converts to a 25% debt-to-equity ratio, what will its cost of equity be?
c. What is Shadow’s WACC after it converts to the 25% debt-to-equity ratio?
d. Assume that converting to the 25% debt-to-equity ratio does not significantly increase Shadow Corp.’s probability of bankruptcy. Should Shadow Corp. convert to the new capital structure? Explain.