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For your company you need to raise $ 4 M. You estimate existing equity to be $ 1 M. If you issue $ 4 M
For your company you need to raise $ 4 M. You estimate existing equity to be $ 1 M. If you issue $ 4 M of equity (so the total equity will be $ 5M), then the required cost of equity will be 16%. Alternatively you can issue a combination of equity and debt. Your bank gave you the following quote for different levels of debt (see below). Your tax rate is 35%
a) Please estimate WACC for each level of debt
b) How much money should you borrow?
c) Why is the debt interest rate increasing with amount of debt? Explain
| Amount needed | $ 4,000,000 |
| Existing equity | $ 1,000,000 |
| Tax rate | 35% |
| Cost of equity (unlevered) | 16% |
| Interest rate table | |
| Amount borrowed | Interest rate |
| $ 500,000 | 6.00% |
| $ 1,000,000 | 7.00% |
| $ 2,000,000 | 8.00% |
| $ 3,000,000 | 10.00% |
| $ 4,000,000 | 12.00% |
| a) Please estimate WACC for each level of debt | |||||||
| Debt | Equity | Debt/Equity | Debt/Value | Interest rate | After tax cost of debt | Cost of equity | WACC |
| $ - | 0.00% | 16% | |||||
| $ 500,000 | 6.00% | ||||||
| $ 1,000,000 | 7.00% | ||||||
| $ 2,000,000 | 8.00% | ||||||
| $ 3,000,000 | 10.00% | ||||||
| $ 4,000,000 | 12.00% | ||||||
| b) How much money should you borrow? | ||||||
| Optimal borrowing | ||||||
| c) Why is the debt interest rate increasing with amount of debt? Explain | ||||||
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