Firm XYZ currently has a capital structure of 30% debt and 70% equity. The cost

Question

Firm XYZ currently has a capital structure of 30% debt and 70% equity. The cost of debt is currently 6% and the cost of equity is 12%. The value of debt is $300 million and the value of equity is $700 million. Let the tax rate equal 34%. An investment banker tells the CFO of the company that if the firm increases its leverage ratio, the cost of debt will increase according to the following schedule: Percentage Percentage Cost of Debt Debt 30% 40% 50% Equity 70% 60% 50% 6% 7% 8% Assume that the cash flow of the firm may be represented as a perpetuity. Determine the WACC for each debt level. Determine the value of the firm for each firm level.

Explanation / Answer

Answer =1 ) IF the Cost of Debt is 6% Calculation of Cost After Debt Aftr Tax Cost OF Debt = Interest ( 1 - Tax) =          6 %       *      ( 1- 0.34) =          6 %       *      0.66 3.96% Cost of Equity = 12% (Given) CALCUALATION OF WACC Particlulars Value Weight Cost WACC = ( Weight* Cost) Equity Stock $                     700 70.00% 12.00% 8.40% Debt $                     300 30.00% 3.96% 1.19% Total $                 1,000 100.00% 9.59% Weight of Equity Stock = Value of Equity of Stock / Total Value = $                          700 "/ " By $             1,000 X 100 = 70% Weight of Debt = Value of Debt / Total Value = $                          300 "/ " By $             1,000 X 100 = 30% Answer = WACC = 9.59% Answer =2 ) IF the Cost of Debt is 7% Calculation of Cost After Debt Aftr Tax Cost OF Debt = Interest ( 1 - Tax) =          7 %       *      ( 1- 0.34) =          7 %       *      0.66 4.62% Cost of Equity = 12% (Given) CALCUALATION OF WACC Particlulars Value Weight Cost WACC = ( Weight* Cost) Equity Stock $                     700 70.00% 12.00% 8.40% Debt $                     300 30.00% 4.62% 1.39% Total $                 1,000 100.00% 9.79% Answer = WACC = 9.79% Answer =3 ) IF the Cost of Debt is 8% Calculation of Cost After Debt Aftr Tax Cost OF Debt = Interest ( 1 - Tax) =          8 %       *      ( 1- 0.34) =          8 %       *      0.66 5.28% Cost of Equity = 12% (Given) CALCUALATION OF WACC Particlulars Value Weight Cost WACC = ( Weight* Cost) Equity Stock $                     700 70.00% 12.00% 8.40% Debt $                     300 30.00% 5.28% 1.58% Total $                 1,000 100.00% 9.98% Answer = WACC = 9.98%

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