Question

Ignacio, Inc., had after-tax operating income last year of $1,198,500. Three sources of financing were used by the company: $2 million of mortgage bonds paying 4 percent interest, $4 million of unsecured bonds paying 6 percent interest, and $10 million in common stock, which was considered to be relatively risky (with a risk premium of 8 percent). The rate on long-term treasuries is 3 percent. Ignacio, Inc., pays a marginal tax rate of 30 percent.

Required:

1. Calculate the after-tax cost of each method of financing. Enter your answers as decimal values rounded to three places. For example, 4.36% would be entered as ".044".

Mortgage bonds
Unsecured bonds
Common stock

2. Calculate the weighted average cost of capital for Ignacio, Inc. Round intermediate calculations to four decimal places. Round your final answer to four decimal places before converting to a percentage. For example, .06349 would be rounded to .0635 and entered as "6.35" percent.

%

Calculate the total dollar amount of capital employed for Ignacio, Inc.

$

3. Calculate economic value added (EVA) for Ignacio, Inc., for last year. If the EVA is negative, enter your answer as a negative amount.

$

Is the company creating or destroying wealth?

Destroying

4. What if Ignacio, Inc., had common stock which was less risky than other stocks and commanded a risk premium of 5 percent? How would that affect the weighted average cost of capital?

What is the new EVA? In your calculations, round weighted average percentage cost of capital to four decimal places. If the EVA is negative, enter your answer as a negative amount.

$

Answer 1

ANSWER

Answer 1.

Cost of Mortgage Bonds ( post tax ) = 0.04 * ( 1 - 0.3) = 0.028

Cost of Unsecured Bonds ( post tax ) = 0.06 * (1 - 0.3) = 0.042

Cost of Stock (using CAPM Model) = Risk free Rate + Risk Premium = 0.03 + 0.08 = 0.110

Answer 2.

Weighted Average Cost of Capital =(2 * 0.028 + 4 *0.042 +10 *0.11) / (2+4+10) = 0.08275 = 8.27%

Total dollar amount of capital employed = 0.08275 * 16,000,000 = 1,324,000

Answer 3.

Economic Value Added

Operating Income after Tax = $ 1,198,500

Less : Cost of Capital employed = $ 1,324,000

Economic Value Added = - $ (125,500) [ It's negative]

Answer 4.

If Risk premium is 5 %

Revised Cost of Stock will be ( 0.03 + 0.05 ) = 0.08

Therefore, Revised WACC = (2 * 0.028 + 4 *0.042 +10 *0.08) / (2+4+10) = 0.064 = 6.4%

Revised EVA will be = $ 1,198,500- [0.064 * 16,000,000 ] = 174,500

Thus EVA becomes positive.

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