Answer:
Debt Equity Ratio =2.5
Weight of debt =2.5/3.5
Weight of Equity =1/3.5
a. WACC =Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt*(1-Tax Rate)
10% = 1/3.5*Cost of Equity Capital+2.5/3.5*6%*(1-35%)
(10%-2.5/3.5*6%*(1-35%))*3.5 = Cost of Equity Capital
Cost of Equity Capital = 25.25%
b) Cost of Levered Equity Capital=Cost of Unlevered Equity Capital+Debt*(1-Tax Rate)/Equity*(Cost of Unlevered Equity Capital-Cost of Debt)
25.25% = Cost of Unlevered Equity Capital+2.5*(1-35%)*(Cost of Unlevered Equity Capital-6%)
Cost of Unlevered equity *(1+2.5*0.65)=(25.25%+2.5*0.65*6%)
Cost of Unlevered Equity =(25.25%+2.5*0.65*6%) / (1+2.5*0.65)
Cost of Unlevered Equity = 13.3333%
c) At debt Equity ratio of 0.75
Cost of Levered Equity Capital = Cost of Unlevered Equity Capital+Debt*(1-Tax Rate)/Equity*(Cost of Unlevered Equity Capital-Cost of Debt)
Cost of Levered Equity Capital= 13.3333% + (13.3333%-6%)*0.75*(1-35%)
Cost of Levered Equity Capital =16.9083%
WACC = Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt*(1-Tax Rate)
WACC = 1/(0.75+1)*16.9083%+0.75/(1+0.75)*6%*(1-35%)
WACC = 11.33%
At debt Equity ratio of 1.50
Cost of Levered Equity Capital=Cost of Unlevered Equity Capital+Debt*(1-Tax Rate)/Equity*(Cost of Unlevered Equity Capital-Cost of Debt)
Cost of Levered Equity = 13.3333% + (13.3333%-6%)*1.50*(1-35%)
Cost of Levered Equity = 18.5333%
WACC =Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt*(1-Tax Rate)
=1/(1+1.30)*18.5333%+1.30/(1+1.30)*6%*(1-35%)
=10.26%
