M&M Proposition 2: X-Pool Filters Ltd has a debt-to-equity ratio of 0.5. If the company's cost of debt is 7% and its cost of equity is 13%, what is the appropriate WACC?
A) 9%
B) 10%
C) 11%
D) 13%.

Question

Quizplus · Accepted Answer

According to M&M Proposition 2, in a world without taxes, the WACC does not depend on the capital structure. Therefore, the appropriate WACC for X-Pool Filters Ltd would simply be a weighted average of its cost of debt and cost of equity, where the weights are based on the market value of each source of capital.

WACC = (Cost of debt x Weight of debt) + (Cost of equity x Weight of equity)

Since the debt-to-equity ratio is 0.5, this means that the market value of debt is equal to half the market value of equity. Thus, the weights would be:

Weight of debt = 0.5 / (0.5 + 1) = 0.33
Weight of equity = 1 / (0.5 + 1) = 0.67

Plugging in the given values, we get:

WACC = (0.07 x 0.33) + (0.13 x 0.67) = 0.0911 or 9.11%

Therefore, the appropriate WACC for X-Pool Filters Ltd is 11%, which is not one of the given choices. We can see that the WACC is higher than the cost of debt and lower than the cost of equity, which is consistent with the fact that the company has a mix of debt and equity in its capital structure.

M&M Proposition 2: X-Pool Filters Ltd Has a Debt-To-Equity Ratio