Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the data shown below. Now the company is considering using some debt, moving to the new debt/assets ratio indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? New Debt/Assets 55% Orig. cost of equity, rs 10.0%
New Equity/Assets 45% New cost of equity = rs 11.0%
Interest rate new = rd 7.0% Tax rate 40%
A) 2.74%
B) 3.01%
C) 3.32%
D) 3.65%
E) 4.01%

Question

Quizplus · Accepted Answer

The correct answer is A because the WACC would change by 2.74% if the company moved to the new debt/assets ratio and repurchased stock. The new WACC would be 8.26%, which is 2.74% lower than the old WACC of 11%. This is because the cost of debt is lower than the cost of equity, and the company would be using more debt and less equity to finance its operations.