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Compton Corporation currently has no debt in its capital structure. As an unlevered firm, its cost...

  1. Compton Corporation currently has no debt in its capital structure. As an unlevered firm, its cost of equity is 13 percent. It is considering substituting $8,000 in debt at 6 percent interest. The EBIT for the firm is $5,000 under either scenario, and the tax rate is 35 percent.

Unlevered Firm Levered Firm

EBIT $5000 $5000

Interest 0 480

EBT 5000 4520  

Taxes (.35) 1750 1582

Net Income 3250 2938

c.         Calculate the cost of equity and the WACC for the levered firm

Solutions

Expert Solution

Value of the unlevered Firm = Earning after tax / Kul = 3250/13% = $25,000

Substitute equity with $8000 debt. Remaining Equity = 25000-8000 = $17000

RL = RUL +(Debt/Equity)(1-t)(RUL-RD)

RL = 13% + ($8000/17000)(1-0.35)(13%-6%)

     = 13% + 2.14%

     = 15.14%

WACC of the Firm = Cost of Equity(Levered) x We + Cost of Debt x(1-t)x Wd

                              = 15.14% x $17000/25000 + 6% x (1-0.35) x $8000/25000

                              = 10.2952% + 1.248%

                              = 11.5432% i.e. 11.54%

jeff jeffy answered 6 months ago
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