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HP and Dell are companies in the exact same business. They both used to have the same capital structure with a debt-to-equity ratio of 1/19. Recently, however, Dell hired many investment bankers and consultants at great expense, and decided to change its debt-to-equity ratio to 1/5. HP figures that they will copy Dell, and move their debt-to-equity ratio to 1/5 as well.
HP doesn’t want to pay for the bankers and consultants that Dell used. Thus, HP relies on you to help them understand the transition.
Assume the following: HP used to have a cost of equity of 20%. Assume that regardless of its capital structure, HP’s cost of debt is 3%. The change in D/E is expected to be permanent. Further, HP’s tax rate is 30%.
[Step 1: de-levering] Find the cost of unlevered equity for HP.
A.16.35%
B.19.00%
C.19.15%
D.22.38%
[Step 2: Re-levering] Find the cost of levered equity for HP under the new capital structure (i.e. the debt-to-equity ratio of 1/5).
A.19.00%
B.17.48%
What is HP’s new WACC?
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