Question

You are reviewing the capital structure of your business. You find that your business is financed with 70% cash and 30% debt.
Your required rate of return for your business is 10%.
Your debt cost is 7%
You are in the 20% tax bracket.
Explain the weighted average cost of capital?
What if you used 80% debt and 20% cash? What would be your new WACC?
How would using more debt in this example affect your profitability as a business?

Answer 1

The meaning of weighted average cost of capital is simply the mean cost of attracting investors, whether bondholders or stockholders.

• WACC = 0.0868
• WACC'' = 0.0648

What would be your new WACC?

Generally, for 30% Debt and 70% Cash,  the Cost of Debt after is mathematically given as

X= 0.07 * (1 – 0.20)

X= 0.056

Therefore

WACC = (0.70 * 0.10) + (0.30 * 0.056)

WACC = 0.0868

In conclusion,  for 80% Debt and 20% Cash

WACC'' = (0.20 * 0.10) + (0.80 * 0.056)

WACC'' = 0.0648

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