Question

Explain why a corporation's WACC would likely increase if it changes the capital structure?

2. The risk as measured in standard deviations of a particular security is 10 percent and the expected return on invested amount is 13. percent. What is the CV for this security? How would you explain this number?

nswer questions a, b, b, and 6 based on the following information from the financial statements of a rporation Total assets $2 billion det Total equity S? billion Total common equity so8 billioniky Cost of preferred stock 10 percent rde Cost of common stock 13 percentg Tax rate 40 percentT Pretax cost of debt 1o percent

a- Calculate the WACC for this corporation? 00.58. What is the capital structure of this corporation in proportions?

b waht is the capital structuer of this corportions in proporions?

c-How much debt this corporation has? Answer the amount of dollars and as a percentage of assets??

Answer 1

1.. Corporation WACC increase if the optimal debt equity structure is not maintained. Some debt is beneficial as cost of debt is tax deductible which reduces the cost of debt. However, excess debt increases the risk of the firm and cost of debt and equity of the firm increases. A all equity firm has higher WACC than a firm with optimal capital; structure because equity is non-tax deductible.

2. CV = (Standard deviation/Return)* 100% = (10/13)* 100% = 76.92%
CV indicates the risk to return ratio of a portfolio. The risk averse investor will try to create a portfolio with low CV.Here the CV is very high as as 0.7692 units of risk is tajke for every 1 unit of return.

3. a) Total Value of firm = DEBT +EQUITY + PREFERRED STOCK =
Debt = Assets - Equity = 2 -1 =1 billion
Preferred stock = Equity - common stock = 1-0.2 = 0.8 billion
Total Value of firm = DEBT +EQUITY + PREFERRED STOCK = 1 + 0.8 + 0.2 = 2 billion

WACC = Weight of equity * cost of equity + Weight of preferred stock * Cost of preferred stock + Weight of debt * cost of debt * ( 1-tax rate)
(0.8/2)* 13% + (0.2/2)* 10% + ( 1/2) * 10% * ( 1-40%) = 9.2%

b))Proportion of equity = (0.8/2) = 40%
Proportion of preferred stock = (0.2/2) = 10%
proportion of debt = (1/2) = 50%

c) Amount of Debt = Assets - Equity = 2 -1 =1 billion
Debt as a percentage of assets = Debt/Assets = 1/2 = 50%

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