You are provided the following information: Debt $ 90000 Equity $ 90000 The shar

ID: 2652236 • Letter: Y

Question

You are provided the following information:

Debt $ 90000

Equity $ 90000

The shares trade at $ 10; the growth rate is 10%. Dividends last year were $ 1.00. The firm has a 40% tax rate.

$ 100 face value, 30 year, 8% coupon bonds trade at par.

1 What is the weighted average cost of capital (WACC) ?

2 What is the WACC if the CFO decides on changing the capital structure to 60% debt and 40% equity?

3 What happens to WACC if the capital structure changes to Debt 40% and 60% equity?

4 What can you say about WACC?

1. For calculation of Weighted Average cost of Capital we have to calculate cost of Debt and Equity:

Cost of Equity: P = D1 / k-g

D1 = Next Year Dividend = 1 x 110% = $1.10

P = $10

g = 10%, k = X

10 = 1.10 / X - 0.10

(X - 0.10) 10 = 1.10

10X - 1 = 1.10

X = 0.21

Cost of Capital = 21%

Cost of Debt:

Formula to calculate YTM : Bond Price = Cashflow x 1 - [1 / (1+ Interest Rate)n ] / Interest Rate + [ Maturity Valuex 1 / (1+ Interest Rate)n ]

YTM = 100 = 8 x 1 - [1 / (1 + 0.08)30] / 0.08 + [100 x 1 / (1 + 0.08)30]

YTM = 8%

After Tax Cost of Debt = 8 x (1 - Tax Rate)

After Tax Cost of Debt = 8x (1 - 0.40) = 4.80%

WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Debt x Cost of Debt)

Proportion of Equity and Debt = 50:50

WACC = (50 x 0.21) + (50 x 0.048) = 12.90%

So, WACC = 12.90%

2. WACC if Capital structure is 60% Debt and 40% Equity

WACC = (40 x 0.21) + (60 x 0.048) = 11.28%

3. WACC if Capital structure is 40% Debt and 60% Equity

WACC = (60 x 0.21) + (40 x 0.048) = 14.52%

4. As we increase more and more Debt, WACC will be decreasing because Debt's Cost is much cheaper than Equity.

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