Touring Enterprises, Inc., has a capital structure consisting of $18 million in

Question

Touring Enterprises, Inc., has a capital structure consisting of $18 million in long-term debt and $7 million in common equity. There is no preferred stock outstanding.

The interest rate paid on the long-term debt is 10%. The firm is in the 35% tax bracket.

On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50.

Based on this information, answer the following questions:

1. Calculate Touring Enterprises' weighted average cost of capital (WACC). Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity. Cite both formulas, and show all your work.

Then, determine the weightings of debt and equity in the capital structure.

Lastly, using your answers to the above questions, calculate the WACC.

2. If Touring Enterprises were to increase the percentage of debt in its capital structure, what would happen to the WACC ? No calculation is necessary- simply provide a short, non-numeric response.

3. Identify and explain the benefits and risks of debt financing. A two-paragraph answer will suffice.

Explanation / Answer

1. Since debt is tax deductible we must take the 10% on the debt and multiply it by (1-tax rate) = (10% * (1-0.35)) = 6.5% cost of equity is found by the gordon growth dividend model where P(E) = (D(1))/(r-g) where P(E) is price per share, D(1) is the next dividend payment, r is the required return on equity (what we are looking for) and g is the growth rate. This is 50 = (1.2*1.05)/(r-.05) Solve for r and we get 7.52% which is the cost of equity. debt is $18m and equity $7m. total capital is the sum of these two amounts or $25M. That makes the weight of debt 72% and the weight of equity as 28%. WACC is the summed of the weights of debt and equity times each ones cost. WACC = (0.72*0.065) + (0.28*0.0752) = 6.79% is the WACC 2. Since debt is lower cost relative to equity increasing debt will lower the WACC. One of the reasons that debt is often cheaper is because it is tax deductible and lower taxable income while equity financing does not. However, debt increases the bankruptcy risk of the firm since interest payments are mandatory.

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