Question: Here is the definition for the weighted average cost of capital (WACC): The WACC is the expected averagefuture cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure. Using this definition and the WACC equation we presented in class,
answer the following questions:
(a) Why does the definition specifically state the "long run cost of capital"?
(b) A firm's long run target of debt and equity capital is respectively, 40-60. Under this long run capitalstructure, the after-tax cost of debt is 5% and after-tax cost of equity is 13%. Calculate the WACC.
(c) The firm's board of directors is considering a long run capital change from a 40-60 mix of debt and equitycapital to 60% debt. Using this new information and the part (b) after-tax cost of debt and equity, calculate the firm's new WACC and clearly state why it is lower than the WACC you calculated in part (b).
(d) Let's assume the board of directors really likes the lower WACC, and decides to change the firm's long-rundebt capital structure to 60%. This decision was made despite the firm's lender stating being more leveragedwill significantly elevate the lender's risk exposure because the firm's default risk will skyrocket. Do you thinkthey will actually realize the lower WACC you calculated in part (c)? Why or why not?
Hint: Consider what the lender might do in response to a 60% debt capital structure.