1. If the cost of new common equity is higher than the cost of internal equity,
ID: 2778273 • Letter: 1
Question
1. If the cost of new common equity is higher than the cost of internal equity, why would a firm choose to issue new common stock?
2. Calculate all MCC break points for the following information:
Total assets = $1,500,000
Total debt = $600,000
Total equity = $900,000
kd is 10% up to $500,000; 11% after $500,000
ks is 13% up to $100,000; 14% after $100,000
3. Your firm’s ks is 10%, the cost of debt is 6% before taxes, and the tax rate is 40%. Given the following balance sheet, calculate the firm’s after tax WACC:
Total assets = $25,000
Total debt = $15,000
Total equity = $10,000
4. Explain the difference between WACC and MCC.
5. What determines whether to use the dividend growth model approach or the CAPM approach to calculate the cost of equity?
Explanation / Answer
a. Compnaies go for common equity rather than internal equity becuase with common equity the company is able to sell bits of its ownership to several investors and is they become a part of the ownership of the company. It is always better for a company to be owned by the retail public at large rather than wholly owned internally. The company would be more transparent and accountable.
b. The Schedule of Debt is as shown Below:
The Scedule of Equity is as shown Below
Now the debt proportion is 0.4 and equity is 0.6
Hence Breakpoint for debt is at 500000, and it would correspond to 500000/0.4 = 1,250,000
Hence the breakpoint in the capital corresponding to debt value of 500,000 would be $1,250,000 (when pretax cost of debt rises from 10% to 11%)
Similarly breakpoint for equity is 100000, and it would correspond to 100000/0.6 = 166.666.67
Hence the breakpoint in the capital corresponding to equity value of 100,000 would be $166.666.67 (when cost of equity rises from 13% to 14%)
3. Cost of equity(ks) is 10%=0.1
Cost of debt (after tax) (kd) = 0.06*(1-0.4) = 0.036
Weight of equity = ws = 0.4
Weight of debt =wd =0.6
Hence WACC is ws*ks + wd*kd = 0.4*0.1 +0.6*0.036 = 0.0616 =6.16%
Hence WACC is 6.16%
4.WACC is the the cost of capital for all projects that are running across the compnay and MCC is the marginal cost of capital to be considered when starting a new project
5.If the dividend, the price of the share and the growth rate of dividends are given we use the Dividend growth model.
If the risk free rate, the market rate and the beta of the business are given, then we calculate cost of equity by CAPM
Debt Schedule Min Max Rate 0 500000 10% 500000 Above 11%Related Questions
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