Estimating the Weighted Average Cost of Capital
Consider the following data:
| Percent Debt | Cost of Debt | Cost of Equity |
|------|-----|------|
| 20% | 5.2% | 6% |
| 40% | 5.6% | 8% |
| 60% | 6.8% | 12% |
Using a tax rate of 30% and the information in the table above, what would be the _most appropriate_ level of debt for this company?
Correct.
The weighted average cost of capital (WACC) at each level would be as follows.
$$\displaystyle (0.2)(5.2)(1-0.3) + (0.8)(6) = 0.0553$$
$$\displaystyle (0.4)(5.6)(1-0.3) + (0.6)(8) = 0.0637$$
$$\displaystyle (0.6)(6.8)(1-0.3) + (0.4)(12) = 0.0766$$
So, having 20% debt provides the lowest cost of capital.
Incorrect.
Calculate the cost of capital for each option.
Incorrect.
At this level of debt, both the cost of debt and the cost of equity have increased substantially, so it is unlikely that this is the lowest cost of capital.
20% debt
40% debt
60% debt
