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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%) × 900,000×(1 – 0.33)/2,397,000 = 16.76%

As shown on the graphs, the geared company has a higher cost of
equity.

(d) Weighted average cost of capital:

WACC = (16.76% × 2,397/3,297) + (8% × (1 – 0.33) 900/3,297) =
13.65%

Alternatively, using M & M's formula:

k adj = k eu (1 – tL) = 15% (1 – 33% × 900/3,297) = 13.65%

Again, notice that this corresponds to the graphs seen above. In the with
tax case, the WACC reduces as the level of debt in the capital structure
increases.

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