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Financing – Capital structure

(c) Cost of debt for Y Co (assuming debt is irredeemable)

k d = Interest/V D = 72,000/900,000 = 8%
Cost of equity for Y Co:

Using M & M's formula:
k eg = k eu + (k eu – k d) V D(1 – t)/V E

k eg = 15% + (15% – 8%) × 0.9/2.1 = 18%
(Alternatively, using the dividend valuation model,

k eg = Dividend/V E = 378,000/2,100,000 = 18%)
As shown on the graphs, the geared company has a higher cost of
equity.

(d) Weighted average cost of capital:

WACC = (18% × 2.1/3) + (8% × 0.9/3) = 15%

Again, notice that this corresponds to the graphs seen above. In the no
tax case, the WACC is constant irrespective of capital structure.

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