Union Brick Inc. (UBI) has a total market value of $200 million, consisting of 2
ID: 2382825 • Letter: U
Question
Union Brick Inc. (UBI) has a total market value of $200 million, consisting of 2 million shares of common stock selling for $50 per share and $100 million of 10 percent perpetual bonds currently selling at par. UBI pays out all earnings as dividends, and its marginal tax rate is 40 percent. The firm’s earnings before interest and taxes (EBIT) are $30 million. Management is considering increasing UBI's debt until its capital structure has 60 percent debt, based on market values. The additional funds will be used to repurchase stock at the new equilibrium price. At the new capital structure, UBI's cost of debt is estimated at 13.182 percent and its cost of equity is estimated to be 10 percent.
What is UBI's weighted average cost of capital (in percentages, i.e., 9% instead of 0.09) at its new capital structure?
Explanation / Answer
Market value of share = Number of share outstanding x Share price per share
Market value of share = 2 million x $ 50 =$ 100 million
Market value of bond = $ 100 million
Total value of firm = Market value of share + Market value of bond = 100 + 100 = $ 200 million
At the new capital structure,
Debt = 60 % and Equity = 40 %
Cost of debt = 13.182 %
Cost of Equity = 10 %
Computation of Weighted Averae Cost of Capital (WACC),We have,
WACC = Cost of equity X E/(E+D) + Cost of debt x (1- tax rate) x D / (E+D)
WACC = 0.10 X 80 / 200 + 0.13183 X ( 1 - 0.40) X 120/200
WACC = 0.04 + 0.0475 = 0.0875*100 = 8.75 %
Hence, the weighted average cost of capital is 8.75%.
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