●    With all-equity financing, a firm’s opportunity cost of capital is 11.80%.
●    The firm refinances to a debt-to-value ratio (D/V) of 45%, at a cost of debt capital rD of 8.60%.
●    The corporate tax rate is 27%.

Question 8.1: Cost of equity capital rE after refinancing

What is the firm’s cost of equity capital rE after the refinancing?

Answer 8.1: If the corporate tax rate is zero, the capital structure does not affect the weighted average cost of capital, which equals the opportunity cost of capital with all-equity financing, which is

        the debt-to-value ratio (D/V) × the cost of debt capital rD × (1 – the corporate tax rate)
 +     the equity-to-value ratio (E/V) × the cost of equity capital rE

For the figures in this practice exam question:

rE × (1 – 45%) + 45% × 8.60% = 11.80%
➾ rE = (11.80% – 45% × 8.60%) / (1 – 45%) = 14.42%

Question 8.2: Weighted average cost of capital after refinancing

What is the firm’s weighted average cost of capital (WACC) after the refinancing?

A.    10.76%
B.    11.29%
C.    11.83%
D.    12.37%
E.    12.91%

Answer 8.2: For the weighted average cost of capital, we include the corporate tax rate of 27%:

    WACC = (45% × 8.60%) × (1 – 27%) + (1 – 45%) × 14.42% = 10.76%