If firms in a certain industry are expected to have a weighted average cost of c

Question

If firms in a certain industry are expected to have a weighted average cost of capital of 20%, calculate the cost of equity based on the cost of debt (ignoring taxes) provided for the firms below. Assume that each firm is worth $10 million.

Firm A: $4 million of debt with a 10% expected return

Firm B: $6 million of debt with a 14% expected return

Firm C: $7 million of debt with a 15% expected return

If bankruptcy costs are $1.2 million and if there is only a 10% chance of bankruptcy occurring, then how much value is lost for each firm due to bankruptcy costs?

Explanation / Answer

Weighted Average Cost of Capital = WACC = 20 %

Firm Value = $ 10 million  

Firm A: Debt = $ 4 million, Equity = Firm Value - Debt = 10 - 4 = $ 6 million, Expected Return on Debt = 10 %

Let the cost of equity ke

20 = ke x (6/10) + 10 x (4/10)

ke = (16 x 10) / 6 = 26.67 %

Firm B: Debt = $ 6 million, Equity = Firm Value - Debt = 10 - 6 = $ 4 million, Expected Return on Debt = 14 %

Let the cost of equity ke

20 = ke x (4/10) + 14 x (6/10)

ke = (11.6 x 10) / 4 = 29 %

Firm C: Debt = $ 7 million, Equity = Firm Value - Debt = 10 - 7 = $ 3 million, Expected Return on Debt = 15 %

Let the cost of equity ke

20 = ke x (3/10) + 15 x (7/10)

ke = (9.5 x 10) / 3 = 31.67 %

Firm A: Bankruptcy Cost = $ 1.2 million, Probability of Bankruptcy = 10 %

Expected Bankruptcy Cost = 0.1 x 1.2 = $ 0.12 million

Firm Value Loss = Expected Bankruptcy Cost = $ 0.12 million

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.