Question

Viza Longstry Communications Incorporated (VCI ) has the following capital structure, which it considers to be optimal:

Debt                                                       40%

Common stock                                    60

Total capital                                         100%

VCI’s tax rate is 40 percent, and investors expect earnings and dividends to grow at a constant rate of 9 percent in the future. VCI paid a dividend of $3.60 per share last year. The current share price is $ 50. Debt could be sold at an interest rate of 12 percent.

Required:

1. Find the weighted average cost of capital for VCI.

2. What would happen to the level of WACC if the company issues additional bonds at market interest rate of 10%, with tax rate and the cost of equity remaining the same? Don’t calculate, and give brief explanation.

3. What would happen to the WACC if the floatation cost is to be incorporated? Explain very briefly.

4. Would additional debt lead to higher cost of equity for VCI? Explain in less than 6 lines.

5. Why VCI is considering the existing debt structure as being optimal? Explain in less than 6 lines.

Answer 1

Cost of equity = Dividend for next year/ Price per share + growth rate

Growth rate = 9%

Price per share = $50

Dividend next year = Dividend paid(1+growth rate)

= 3.60(1+9%)

= 3.60(1.09)

= 3.924 $

Thus Cost of equity = 3.924/50 + 0.09

= 0.07848 + 0.09

= 0.16848

i.e 16.848 %

Cost of debt = Interest rate(1-tax rate)

= 12% ( 1-40%)

=12%(1-0.4)

=12%(0.6)

=7.2%

1) Statement showing WACC

Particulars	Weight	Cost of capital	WACC
a	b	c =axb
Equity	60%	16.848%	10.11%
Debt	40%	7.200%	2.88%
WACC			12.99%

Thus WACC = 12.99%

2) If company issues additional bonds at market interest rate of 10% , than WACC will reduce as cost of this new debt will be just [10%(1-0.4) = 10%(0.6)] 6% given that the cost of equity remains same

3) If the floatation cost is to be incorporated, then cost of equity and cost of debt will increase resulting in increase of WACC

4) Yes, Additional debt will lead to higer cost of equity , as debt comes with risk of bankrupcy, equity share holder will demand higher return to compensate that risk

5) Debt to equity ratio of VCI is = 40%/60% = 0.6667 which is less than 1. That is the reason that  VCI is considering the existing debt structure as being optimal