The Ricardo Corporation has a weighted average cost of capital (ignoring taxes) of 12 percent. It can borrow at 8 percent. Assuming that Ricardo has a target capital structure of 80 percent equity and 20 percent debt, what is its cost of equity? What is the cost of equity if the target capital

Question

The Ricardo Corporation has a weighted average cost of capital (ignoring taxes) of 12 percent. It can borrow at 8 percent. Assuming that Ricardo has a target capital structure of 80 percent equity and 20 percent debt, what is its cost of equity? What is the cost of equity if the target capital structure is 50 percent equity? Calculate the WACC using your answers to verify that it is the same.

Accepted Answer

According to M&M Proposition II, the cost of equity, R[latex]_{E}[/latex], is:
[latex]R_{E} = R_{A} + (R_{A} − R_{D}) × (D/E)[/latex]

In the first case, the debt-equity ratio is .2/.8 = .25, so the cost of the equity is:

[latex]R_{E}[/latex] = .12 + (.12 − .08) × .25
= .13, or 13%

In the second case, verify that the debt-equity ratio is 1.0, so the cost of equity is 16 percent. We can now calculate the WACC assuming that the percentage of equity financing is 80 percent, the cost of equity is 13 percent, and the tax rate is zero:

WACC = [latex](E/V) × R_{E} + (D/V) × R_{D}[/latex]
= .80 × .13 + .20 × .08
= .12, or 12%

n the second case, the percentage of equity financing is 50 percent and the cost of equity is 16 percent. The WACC is:

WACC = [latex](E/V) × R_{E} + (D/V) × R_{D}[/latex]

= .50 × .16 + .50 × .08
= .12, or 12%

As we have calculated, the WACC is 12 percent in both cases.

Question 16.3: The Ricardo Corporation has a weighted average cost of capit...

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