Touring Enterprices, Inc., has a capital structure of $18 million in long-term d

Question

Touring Enterprices, Inc., has a capital structure 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 dividends by 5% per year. The market price of the stock is $50.

Based on this information. answer the folling questions:

1) Calculate Touring Enterprises weighted average cost of capital (WACC). Work as follows: First compute the aftertax cost of debt, then compute the cost of equity. Cite both formulas and show all 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 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) Data:

Formula= After tax cost of debt= (wd) * (kd)(1-T)

Weight of debt=18/25 *100= 72%
Weight of common equity=7/25*100=28%

kd=10%
tax rate=35%

After tax cost of debt= (wd) * (kd)(1-T)
(72%)*(10%)(1-.35)
After tax cost of debt= 4.68%

cost of common equity=
Formula= ks=d1/po + g
where ks= cost of common equity
d1= dividend 1
p0= current market price
g=growth rate

ks=1.26/50 +5%=
ks=7.52%

Wacc=wd*kd(1-t) + (wce)(kce)
wacc= 4.68%+(28%)(7.52%)
wacc= 4.68%+2.1056%
wacc= 6.7856%

2) cost of capital will decrease if we increase weight of debt.
3) see 2.

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