In general, as the higher level of debt results in a higher degree of leverage, companies can benefit from the tax shield by incurring debt, however, adding debt also increases the risk of bankruptcy. So the Net effect on WACC is uncertain as it really depends on the level of debt. But it is rational to think in the way that the cost of capital would start increasing after a certain point when more debt is used, because at that point the cost outweigh the benefit.

So, coming back to our case, assuming that the company issued 3 billion in debt, we will do some calculation to see how the change in capital structure affect the company’s WACC.

This is how we calculated the WACC before the 3 billion debt. We can first find the cost of equity by using CAPM, and the risk-free rate that we used here is the 20 year treasury yield. And we have come up with the answer of 10.9% for cost of equity. Since the company has no debt at this time, the WACC is simply equal to 10.9%

After the recapitalisation, we have to recalculate the beta because according to the M&M theory: If a firm changes its financial leverage, the firm’s beta will change. And this is basically due to the increase of risk. So as the beta we just calculated is already a unlevered one, we can simply use that number to relever the beta, and we get .85 Then, using the relever beta to come up with a new cost of equity, we get 11.6%

Last step, substitute the new cost of equity, and include the after tax cost of debt, we have a similar result, which is 10.91%