Question 1. You are a corporate finance analyst at a management consulting firm,

Question

Question 1. You are a corporate finance analyst at a management consulting firm, which has been approached by a company for advice on its capital structure decisions. The company, Boston Turkey Inc. has been in existence for only two years, and its stock is currently trading at $20 per share (There are 100,000 shares outstanding.) The following are the most recent financial statements of the company: Income Statement Revenues Expenses Depreciation EBIT Interest Expense Taxable Income Tax Net Income 1.000.000 $400,00 $100,000 S500,000 $100,000 $400,000 S160,000 S240,000 Balance Sheet $1,000,000 Accounts payable$500,000 S500,000 Long Term Debt 1,500,000Equity (100,000 Current Assets $1,000.000 $1,500,000 Land & Buildings Property, Plant & ent shares) Total Assets S3,000,000 Total Liabs. & $3,000,000 Equity Due to its limited history, the beta of the stock cannot be estimated from past prices. You do have information about comparable listed firms and their betas Debl/Equity Ratio Firm Arizona's Baked Chicken Barbee's Chicken Eyepop's Chicken Beta 1.05 1.20 0.90 20% 50% 10% 70% Bob Roy Chicken &Fish; 1.35

Explanation / Answer

a)

Long term Debt = 1000000

Equiy (Market value) = 100000*20 = 2000000

Debt Equity Ratio = 1000000/2000000 = 50%

therefore company current Debt Equity Ratio is matched with Company Barbee Chicken

than Companys Beta = 1.20

Market Risk Premium = 5.5%

Risk Free Rate = Tresury Bill Rate = 3%

As per CAPM

Cost of Equity = Risk Free Rate + Market Risk premium *beta

Cost of Equity = 3 + 5.5*1.20

Cost of Equity = 9.60%

b)

Interest Coverage Ratio = EBIT/Interest Expenses

Interest Coverage Ratio = 500000/100000

Interest Coverage Ratio = 5

On the basis of Coverage ratio, Rating lies on A, therefore Spread over T-Bond = 1.25%

Cost of Debt = Tresury Bond rate + Spread

Cost of Debt = 6.25% + 1.25%

Cost of Debt = 7.50%

But the Company is not rated ,

Best estimate would be treating the Book value of debt be market value

Cost of Debt = Interest Expenses/Long term bond

Cost of Debt = 100000/1000000

Cost of Debt = 10%

Tax rate = 160000/400000 = 40%

After tax cost of Debt = cost of Debt * (1-tax rate)

After tax cost of Debt = 10%*(1-40%)

After tax cost of Debt = 6%

c)

Current Cost of Capital = Weight of Equity*Cost of Equity + Weight of Debt*aftertax cost of debt

Current Cost of Capital = 1/(1+0.50) * 9.60 + 0.50/(1+0.50) *6

Current Cost of Capital = 8.40%

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