Use the information for the question(s)below.
KT Enterprises is considering undertaking a new project.Based upon analysis of firms with similar projects,KT has determined that an unlevered cost of equity of 12% is suitable for their project.KT's corporate tax rate is 21%,its borrowing rate is 7%,and KT does not believe that its borrowing rate will change if the new project is accepted.
-If KT expects to maintain a debt to equity ratio for this project of .6 then KT's project-based WACC,rwacc,for this project is closest to:
A)10.5%.
B)11.5%.
C)9.6%.
D)10.8%.

Question

Quizplus · Accepted Answer

First, we need to calculate the cost of equity with leverage using the debt to equity ratio of 0.6:

Equity = 1 - debt/equity = 1 - 0.6 = 0.4

Cost of equity with leverage = unlevered cost of equity + (unlevered cost of equity - borrowing rate) * (1 - corporate tax rate) * debt/equity
= 0.12 + (0.12 - 0.07) * 0.79 * 0.6/0.4
= 0.115 or 11.5%

Then, we can calculate the project-based WACC using the debt to equity ratio of 0.6:

rwacc = cost of equity with leverage * equity + borrowing rate * (1 - corporate tax rate) * debt/equity
= 0.115 * 0.4 + 0.07 * 0.21 * 0.6/0.4
= 0.08925 or 8.925%

However, this is the WACC before tax. To get the project-based WACC after tax, we need to adjust for the tax shield:

rwacc = (cost of equity with leverage * equity + borrowing rate * debt/equity) * (1 - corporate tax rate)
= (0.115 * 0.4 + 0.07 * 0.6/0.4) * 0.79
= 0.10745 or 10.745%

The closest choice is B) 11.5%.

Use the Information for the Question(s)below