Leverage and the Cost of Capital. “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...

Leverage and the Cost of Capital. “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 5%, and the cost
of equity is 10%. The company now makes a further $250,000 issue of debt and uses the
proceeds to repurchase equity. This causes the cost of debt to rise to 6% and the cost of equity
to rise to 12%. Assume the firm pays no taxes. (LO16-1)
a. How much debt does the company now have?
b. How much equity does it now have?
c. What is the overall cost of capital?