Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

Increase in debt ratio will decrease the WACC by 1.12% ( 10.4% to 9.28% )

Explanation:

WACC is the average cost of capital of the firm based on the weightage of the debt and weightage of the equity multiplied to their respective costs.

According to WACC formula

WACC = ( Cost of equity x Weightage of equity )+ ( Cost of debt ( 1- t) x Weightage of debt )

50% debt ratio

WACC = ( 16% x 50% )+ ( 8% ( 1- 0.4) x 50% )

WACC = 8% + 2.4%

WACC = 10.4%

60% debt ratio

WACC = ( 16% x 40% )+ ( 8% ( 1- 0.4) x 60% )

WACC = 6.4% + 2.88%

WACC = 9.28%

WACC will decrease by 1.12% ( 10.4%-9.28%)

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