The Wolves Company is financed by 50% debt, and 50% equity.Their debt has an 8.5

Question

The Wolves Company is financed by 50% debt, and 50% equity.Their debt has an 8.5% annual interest rate. Their published Beta Coefficient is 1,57. The Risk Free Rate on U.S Treasury Securities is 5% and the return on the market portfolio is 10%. Wolves in not sure that they have the optimum mix of debt and equity. They are considering the following debt/equity capital structures. 1) Compute Wolves present weighted average cost of capital. 2) Compute the weighted average cost of capital for each potential structure. Assume a 40% corporate tax rate. Should Wolves change their capital Structure? If so, to which of the following structures? why? ( show all work)

a- 40% debt with 8% coupon rate, and 60% equity

b- 60% debt with 9% coupon rate, and 40% equity

c-80% debt with a 10% coupon rate, and 20 % equity

Explanation / Answer

Dear Colleague,

First Let us find the Cost of Equity

The Cost of Equity as per the Capital Asset Pricing Model (CAPM) is given by:

Cost of Equity (Ke) = Rfr (Risk Free Rate) + B(Beta)*(Rm - Rfr) ... (Rm = Returs of the market portfolio)

Thus Ke = 5% + 1.57 ( 10% -5%) = 12.85%

Current Debt/Equity RAtio is 50/50.

Current Cost of Debt = 8.50%

Post Tax Rate = coupon * (1- tax rate) = 8.50 *(1-40%) = 5.10%

1) Thus Current Weighted Average Cost of Capital (WACC) = (Debt * Post Tax Cost of debt) + (equity * cost of equity)

= (50% * 5.10%) + (50% * 12.85%) = 8.975 %

2) Three Different Scenarios of Debt Equity Combination:

a) Debt 40% with 8% coupon and 60% Equity

Post Tax Cost of Debt = 8% * (1-40%) = 4.80%

WACC = (40% * 4.80%) + (60% * 12.85%) = 9.63%

b) Debt 60% with coupon 9% and Equity 40%

Post Tax Cost of Debt = 9% * (1-40%) = 5.40%

WACC = (60% * 5.40% ) + (40% * 12.85%) = 8.38%

c) Debt 80% with coupon 10% and Equity 20%

Post Tax cost of Debt = 10% (1- 405) = 6%

WACC = (80% * 6%) + ( 20% *12.85%) = 7.37%

Considering the above WACC scenarios, the Wolves company should change their current capital structure of 50/50 Debt and Equity and pursue the Capital structure of Debt 80% at coupon rate of 10% and Equity 20%.

This is because it provided the Wolves Comapny to operate at the lowest Weighted Average Cost of Capital of 7.37% per annum.

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.