Problem 16-10 Leverage and the Cost of Capital (LO1)
"Increasing financial leverage increases both the cost of debt (rdebt) and the cost of equity (requity). So the overall cost of capital
cannot stay constant." This problem is designed to show that the speaker is confused. Buggins Inc. is financed equally by debt and
equity, each with a market value of $1 million. The cost of debt is 9%, and the cost of equity is 14%. The company now makes a further
issue of debt and uses the proceeds to repurchase equity. This causes the cost of debt to rise to 10% and the cost of equity to rise to
16%. Assume the firm pays no taxes.
a. After the debt issue, what percent of the firm is financed with debt? (Do not round intermediate calculations. Enter your answer as
a whole percent.)
Percentage of debt
%
b. After the debt issue, what percent of the firm is financed with equity? (Do not round intermediate calculations. Enter your answer
as a whole percent.)
Percentage of equity
%
c. What is the overall cost of capital? (Enter your answer as a percent rounded to 1 decimal place.)
