Wacky Tobacco, Inc. (WTI) is a publicly traded corporation headquartered in California. WTI’s CFO is calculating its weighted average cost of capital (WACC). WTI has obtained capital by selling stock and issuing bonds. The lenders who bought WTI’s bond expect a return of 6 percent. WTI’s stockholders expect a return of 12 percent on their investment. The value of the firm is $500 million, consisting of $200 million in bonds and $300 million in stock. WTI’s tax rate is 30 percent.

Calculate WTI’s WACC.

Calculate WTI’s after-tax cost of debt

Assume WTI sells another $100 million in bonds. Recalculate WTI’s WACC, assuming all other values for this question remain the same except the value of the firm, which now equals $600 million.

Explain why firms that increase their leverage (like WTI) rely more heavily on effective risk management.