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Weighted Average Cost of Capital - WACC calculation

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A company is funded equally by debt and equity and investors expect 12% per annum return from investing in the firms equity and 4% (net of tax) per annum to invest in its debt. What is the firms WACC? If the firm suffers a credit downgrade and investors require a return of 6% (net of tax) what is the new WACC?

Also, how does the WACC change as firms add to debt relative to equity? Why is it unreasonable to think that WACC cannot be reduced to the (original and unchanging) cost of debt itself as the proportion of debt on the balance sheet rises?

Please provide clear breakdown of answers to the above with clear/simple commentary.

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Solution Summary

The solution computes the WACC and provides answers to the above questions.

Solution provided by:
Radhika Lakshmi, MPhil
Education
  • MPhil, Madurai Kamaraj University
  • MCom, Annamalai University
  • IATA, International Air Transport Association
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