Question

Dingel Inc. is attempting to evaluate three alternative capital structures - A,B,C. The following table shows the three structures along with relevant cost data. The firm is subject to a 40% tax rate. The risk-free rate is 5.3% and the market return is currently 10.7%

		Capital Structure
Item	A	B	C
Debt($ million)	35	45	55
Preferred Stock ($ million)	0	10	10
Common Stock ($ million)	65	45	35
Total Capital	100	100	100
Debt (yield to maturity)	7.0%	7.5%	8.5%
Annual Preferred Stock Dividend	-	$2.80	$2.20
Preferred Stock (Market Price)	-	$30.00	$21.00
Common Stock Beta	.95	1.10	1.25

(a) Calculate the after-tax cost of debt for each capital structure

(b) Calculate the cost of preferred stock for each capital structure

(c) Calculate the cost of common stock for each capital structure

(d) Calculcate the weighted average cost of capital (WACC) for each capital structure

(e) compare the WACCs calculated in part (d) and discuss the impact of the firm's financial leverage on its WACC and its related risk

Please include detail of work

Answer 1

a) After tax cost of debt = YTM * (1 - Tax rate)

Here, Tax rate = 40% or 0.40

For capital structure

A : YTM = 7% or 0.07

After tax cost of debt = 0.07 * (1 - 0.40)

After tax cost of debt = 0.042 or 4.2%

B : YTM = 7.5% or 0.075

After tax cost of debt = 0.075 * (1 - 0.40)

After tax cost of debt = 0.045 or 4.5%

C : YTM = 8.5% or 0.085

After tax cost of debt = 0.085 * (1 - 0.40)

After tax cost of debt = 0.051 or 5.1%

b) Cost of preferred stock = Dividend / Price

For capital structure

A : Nil

B : Cost of preferred stock=$2.80/$30 = 0.093 or 9.3%

C : Cost of preferred stock = $2.20/$21

Cost of preferred stock = 0.1048 or 10.48%

c) Cost of common stock = Rf + Beta * ( Rm - Rf)

Here, Rf (Risk free rate) = 5.3% or 0.053

Rm (Market return) = 10.7% or 0.107

For capital structure

A : Beta = 0.95

Cost of common stock = 0.053 + 0.95 * (0.107 - 0.053)

Cost of common stock = 0.053 + 0.0513

Cost of common stock = 0.1043 or 10.43%

B : Beta = 1.10

Cost of common stock = 0.053 + 1.10 * (0.107 - 0.053)

Cost of common stock = 0.053 + 0.0594

Cost of common stock = 0.1124 or 11.24%

C : Beta = 1.25

Cost of common stock = 0.053 + 1.25 * ( 0.107 - 0.053)

Cost of common stock = 0.053 + 0.0675

Cost of common stock = 0.1205 or 12.05%

d) WACC = (Weight of debt * Cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common stock)

For capital structure

A : Weight of debt = 35% or 0.35

Weight of common stock = 65% or 0.65

Weight of preferred stock = Nil

Now use the above calculated details in formula,

WACC = (0.35 * 0.042) + Nil + (0.65 * 0.1043)

WACC = 0.0147 + 0.0678 = 0.0825 or 8.25%

B : Weight of debt = 45% or 0.45

Weight of preferred stock = 10% or 0.10

Weight of common stock = 45% or 0.45

Now use the calculated details in formula,

WACC = (0.45 * 0.045) + (0.10 * 0.093) + (0.45 * 0.1124)

WACC = 0.0203 + 0.0093 + 0.0506 = 0.0802 or 8.02%

C : Weight of debt = 55% or 0.55

Weight of preferred stock = 10% or 0.10

Weight of common stock = 35% or 0.35

Now use the calculated details in formula,

WACC = (0.55 * 0.051) + (0.10 * 0.1048) + (0.35 * 0.1205)

WACC = 0.0281 + 0.0105 + 0.0422 = 0.0808 or 8.08%

e) WACC is decreasing when firm is using financial leverage in the form of debt.