Suppose that a TV manufacturing company is currently financed with 30% debt and 70% equity (at market values). The required return on equity is 15%, and the required return on debt is 5%. For all parts of this question, assume that the Modigliani-Miller theorem holds (i.e., there are no frictions such as taxes, costs of financial distress, asymmetric information, etc.).
(a) What is the company’s weighted-average cost of capital?
(b) The company decides to raise additional funds by issuing some more debt. After doing so, its capital structure changes to 40% debt and 60% equity. Assume, for now, that the issue is sufficiently small to not change the cost of debt (which therefore continues to be 5%). What is the company’s weighted-average cost of capital after the debt issuance? What is the required return on the company’s equity? 1
(c) Assume now that the capital structure change described in part (b) did raise the cost of debt after all, from 5% to 6%. What is the company’s weighted-average cost of capital after the debt issuance, given that the cost of debt has risen to 6%? What is the required return on the company’s equity?