The following problems are based on the chart & information: The firm\'s policy
ID: 2645994 • Letter: T
Question
The following problems are based on the chart & information:
The firm's policy is to use a risk premium of 6 percentage points when using the bond-yield-plus-risk-premium method to find cost of equity.The company?s bonds are selling for $1025 currently, have 7 years to maturity, with 9% coupon rate with semi-annual payments.
The company?s tax rate is 40%.
A) What is the debt ratio of this company?
B) What is the WACC of this company using the debt ratio assuming nothing else is given?
C) What is the WACC of this company using the book values of the capital structure?
**Any help would be great!!**
Balance Sheets 014 10,000 375,000 615,000 1,000,000 2,000,000 sets ccounts receivable Inventories Fixed Assets Total Assets Liabilities and Equift Payables Accruals Short term bank loans Total current liabilities. ong term bonds ($1000 par) Common stock( $1 par) Retained earnings Total Liabilities and Equit 200,000 110,000 310,000 750,000 130,000 810,000 2,000,000Explanation / Answer
A) Debt ratio = total liabilities / total assets = (current liabilities + LT bonds) / total assets = (310,000 + 750,000) / 2,000,000 = 53%
B) We cannot calculate WACC using ONLY the Debt Ratio & no other information, because WACC has 4 components: Cost of Equity, Cost of Debt, Proportion of Equity & propotion of debt in capital structure. The Debt ratio provides a relationship between debt and assets, not between debt and equity.
(C) Using book value of capital structure:
9% coupon with semi-annual payment = (1.045)2 - 1 = 9.2% effective annual coupon rate
so cost of equity = 9.2% + 6% = 15.2%
and cost of debt (for WACC purposes) = Coupon rate x (1 - tax rate) = 9.2% x (1 - 0.4) = 5.52%
% of equity stock = 130,000 / (130,000 + 750,000) = 14.77%
% of debt = 750,000 / (130,000 + 750,000) = 85.23%
So
WACC = (% of equity capital x cost of equity) + (% of debt x cost of debt)
= (14.77% x 15.2%) +( 85.23% x 5.52%) = 2.25% + 4.7% = 6.95%
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