Question

Calculating Weighted Average Cost of Capital and Economic Value Added (EVA)

Ignacio, Inc., had after-tax operating income last year of $1,197,000. 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? Creating or 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? Higher, Lower, or Unaffected

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

1.

Cost of Debt = Rate * (1 – Tax Rate)

Mortgage Bonds = 2.8% {4% * (1 – 0.3)}

Un-Mortgage Bonds = 4.2 % {6% * (1 – 0.3)}

Cost of Equity = Risk Premium + Rate on Long term treasuries

Cost of Equity = 11% (8% + 3%)

2.

Source	Book Value	Weight (Book Value / Total Book Value)	Cost of Capital	WACC
Debt
Mortgage	2,000,000	12.50%	2.80%	0.35%
Un-Mortgage	4,000,000	25.00%	4.20%	1.05%
Equity	10,000,000	62.50%	11.00%	6.88%
Total	16,000,000	100%		8.28%

3.

EVA = Net Profit – (Capital Employed * WACC)

= $1,197,000 – ($16,000,000 * 8.28%)

EVA = ($127,800)

So the EVA is negative so it is destroying wealth.

4.

New Cost of Equity = 8% (5% + 3%)

WACC
Source	Book Value	Weight (Book Value / Total Book Value)	Cost of Capital	WACC
Debt
Mortgage	2,000,000	12.50%	2.80%	0.35%
Un-Mortgage	4,000,000	25.00%	4.20%	1.05%
Equity	10,000,000	62.50%	8.00%	5.00%
Total	16,000,000	100%		6.40%

So the WACC is decreased.

EVA

New EVA = $1,197,000 – ($16,000,000 * 6.4%)

EVA = $173,000

So the EVA is Positive so it is Creating wealth.

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