Reading: Adjusting the Capital Structure

Next, let us look at the impact of the leveraged recapitalization on the firm's cost of capital. Note that, since the firm's operating activities have not changed, the cost of assets (k_A) will remain at 11.7%. But what about the cost of equity (k_E) as well as the firm's WACC?

We have compiled the following information about the firm after the recapitalization (regardless of how the firm distributes the 250 billion):

• Equity value (E*) = 425 billion
• Net debt (D*) = 100 billion
• Debt tax shield (DTS*) = 30 billion
• Cost of debt (k_D) = 2%
• Tax rate (t) = 30%.

With this information, we can compute the cost of equity as well as the WACC after the transaction (as before, the asterisk modifyer * denotes the situation after the transaction):

\( k_E^* = k_A + (k_A - k_D^*) \times \frac{D^*-DTS^*}{E^*} = 0.117 + (0.117 - 0.02) \times \frac{100-30}{425} \) =  13.3%

\( WACC^* = k_A \times (1- \tau \times \frac{D^*}{D^*+E^*}) = 0.117 \times (1 - 0.3 \times \frac{100}{100+425}) \) = 11.0%

Interpretation:

• Because of the more aggressive financing policy, the shareholders now require a rate or return that exceeds the cost of assets (13.3% vs. 11.7%). The reason is that they now bear business risk as well as financing risk.
• The WACC, in turn, drops below the cost of assets (11.0% vs. 11.7%) because of the tax savings associated with the firm's debt financing.