3. Botswana Corporation has 34% debt and 66% equity (market values) in its capit

Question

3. Botswana Corporation has 34% debt and 66% equity (market values) in its capital structure. The pretax cost of debt is 8.5%, and that of equity 13%. The total value of the company is $22 million and its income tax rate is 29%. Botswana has to raise $3 million in new capital, which will make the expected EBIT of the company to be $2.1 million, with a standard deviation of $1 million. The company has decided to raise the new capital half with debt and half with equity at the existing rates. Calculate Botswana's new WACC, and the probability that its interest coverage ratio will be less than one. Answer should be WACC = 10.50% and the probability = 9.066%.

Explanation / Answer

New debt = 34%*22 + 3/2= 8.98 million

Neq equity = 66%*22 + 3/2= 16.02 million

New value of company = 22+3 = 25 million

WACC = E/V*re + D/V*rd*(1-t) = 16.02/25*13% + 8.98/25*8.5%*(1-29%)= 10.50%

Interest = 8.98*8.5%=0.7633 million

interest coverage ratio < EBIT/Interest < 1

EBIT < 1*0.7633

EBIT <0.7633 million

Uisng probability theory

x= mean +- z*std deviation

2.1 - z*1 <0.7633

z<1.3367

Using normal distriution tables,

P value for z<1.3367 = 0.09066

Probabilty = 0.09066 or 9.066%

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