2. Here is the definition for the weighted average cost of capital (WACC): The WACC is the expected averagefuture cost of capital over the long run; found by weighting the cost of each specific type of capital by its
proportion in the firmâs capital structure. Using this definition and the WACC equation we presented in class,
answer the following questions:
(a) Why does the definition specifically state the âlong run cost of capitalâ?
(b) A firmâs long run target of debt and equity capital is respectively, 40-60. Under this long run capitalstructure, the after-tax cost of debt is 5% and after-tax cost of equity is 13%. Calculate the WACC.
(c) The firmâs board of directors is considering a long run capital change from a 40-60 mix of debt and equitycapital to 60% debt. Using this new information and the part (b) after-tax cost of debt and equity, calculate the
firmâs new WACC and clearly state why it is lower than the WACC you calculated in part (b).
(d) Letâs assume the board of directors really likes the lower WACC, and decides to change the firmâs long-rundebt capital structure to 60%. This decision was made despite the firmâs lender stating being more leveragedwill significantly elevate the lenderâs risk exposure because the firmâs default risk will skyrocket. Do you thinkthey will actually realize the lower WACC you calculated in part (c)? Why or why not? Hint: Consider what the lender might do in response to a 60% debt capital structure
2. Here is the definition for the weighted average cost of capital (WACC): The WACC is the expected averagefuture cost of capital over the long run; found by weighting the cost of each specific type of capital by its
proportion in the firmâs capital structure. Using this definition and the WACC equation we presented in class,
answer the following questions:
(a) Why does the definition specifically state the âlong run cost of capitalâ?
(b) A firmâs long run target of debt and equity capital is respectively, 40-60. Under this long run capitalstructure, the after-tax cost of debt is 5% and after-tax cost of equity is 13%. Calculate the WACC.
(c) The firmâs board of directors is considering a long run capital change from a 40-60 mix of debt and equitycapital to 60% debt. Using this new information and the part (b) after-tax cost of debt and equity, calculate the
firmâs new WACC and clearly state why it is lower than the WACC you calculated in part (b).
(d) Letâs assume the board of directors really likes the lower WACC, and decides to change the firmâs long-rundebt capital structure to 60%. This decision was made despite the firmâs lender stating being more leveragedwill significantly elevate the lenderâs risk exposure because the firmâs default risk will skyrocket. Do you thinkthey will actually realize the lower WACC you calculated in part (c)? Why or why not? Hint: Consider what the lender might do in response to a 60% debt capital structure
