An unlevered firm has a cost of capital of 12.46 percent and a tax rate of 35 percent. The firm is considering a new capital structure with 35 percent debt. The interest rate on the debt would be 6.68 percent. What would be the firm's levered cost of capital if they undertake this new capital structure?


Multiple Choice

13.94%


14.27%


14.48%


14.78%


13.90%

To calculate the firm's levered cost of capital (also known as the **WACC** or weighted average cost of capital), we can use the **Modigliani-Miller Proposition II with Taxes**, which states:

\[
r_L = r_U + \frac{D}{E} \times (r_U - r_D) \times (1 - T_C)
\]

Where:
- \( r_L \) = Levered cost of capital (WACC)
- \( r_U \) = Unlevered cost of capital (12.46%)
- \( r_D \) = Cost of debt (6.68%)
- \( D/E \) = Debt-to-equity ratio (based on 35% debt, so D/E = 0.35 / 0.65)
- \( T_C \) = Tax rate (35%)

First, we calculate the **Debt-to-Equity ratio** \( \frac{D}{E} \):

\[
\frac{D}{E} = \frac{0.35}{0.65} = 0.5385
\]

Now, applying the values to the formula for the levered cost of capital:

\[
r_L = 12.46\% + 0.5385 \times (12.46\% - 6.68\%) \times (1 - 0.35)
\]

Let's solve for \( r_L \).The firm's levered cost of capital (WACC) is **14.48%**. Thus, the correct answer is:

**14.48%**.

Would you like any further details or explanations?

Here are some related questions for further exploration:
1. How does the tax shield benefit impact the WACC in this scenario?
2. How would a higher debt percentage affect the levered cost of capital?
3. What would happen to the WACC if the cost of debt increased?
4. How would the WACC change if there were no taxes?
5. How does the Modigliani-Miller theorem relate to the firm's capital structure?

**Tip:** Increasing debt can lower the cost of capital due to the tax shield, but only to a certain extent before the cost of financial distress outweighs the benefits.

An unlevered firm has a cost of capital of 12.46 percent and a tax rate of 35 percent. The firm is considering a new capital structure with 35 percent debt. The interest rate on the debt would be 6.68 percent. What would be the firm's levered cost of capital if they undertake this new capital structure?

Learn how to calculate the levered cost of capital for a firm using the Modigliani-Miller Proposition II with taxes. This problem includes a detailed explanation of key concepts such as WACC, the debt-to-equity ratio, and the impact of taxes on capital structure. Suitable for finance students at the undergraduate or MBA level.

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