Question

A Company has a total Debt of $500,000 and its Equity is $500,000. Short-term debt is 35.00% of its Total Debt and costing 8.0% while its Long-term debt is costing 6.0%. The cost of Equity is found using D1 = $2.00, Po = $20.00 while its growth is 2.0%. Find the Cost of Capital for the Company if the Corporate Tax is 45.00%.

Question 7 options:

	7.8742%
	9.2534%
	7.8425%
	8.8425%

Question 8

A Company has a Cost of Capital of 25.25%, and has decided to invest into a new project costing $27,451. It expects the total cash flow to be in year 1 = $50,000, year 2 = -$5,000, year 3 = -$15,326, year 4 = $98,500 and the final year to be: -$40,000. Find the NPV of the project and decide if you should: Accept or Reject it.

Question 8 options:

	-$60,250.3287, Reject
	$60,250.3287, Accept
	-$28,529.4349, Reject
	$28,529.4349, Accept

Answer 1

Out of above questions, question 7 is being answered (as no specific information given)

Ans - In the given case, we have

Total Debt = $500000 (Short term Debt = 35% of total debt i.e $175000 and Long term debt =Total Debt - Short term debt i.e 500000-175000 = $325000)

We have,

1. Cost of short term debt i.e 8% (before Tax)

Thus, cost of Short term debt after tax = 8-(8*0.45) = 4.4%

2. Cost of Long Term Debt i.e 6% (Before Tax)

Thus, Cost of long term debt after tax = 6-(6*0.45) = 3.3%

3. Now we need to calculate cost of equity by using following.

D1 = $2, P0 = $20, g (Growth) = 2%

Thus we can use formula i.e P0 = D1/(Re-g)

Thus Re (Cost of Equity) = (D1/p0)+g

Thus Re = (2/20) + 0.02 = 12%

Thus to calculate cost of capital of company i.e (WACC), we need to use following formula

i.e WACC = (Weight of Short term debt * Cost of Short term debt) + (Weight of Long term debt * Cost of long term debt) + (Weight of Equity * Cost of equity)

Here,

Weight of short term debt out of total capital = 175000/1000000 = 17.5%

Weight of Long term debt out of total capital = 325000/1000000 = 32.5%

Weight of Equity out of total capital = 500000/1000000 = 50%

Cost of Short term debt after tax = 4.4%

Cost of long term debt after tax = 3.3%

Cost of equity = 12%

Thus WACC = (0.175*4.4) + (0.325*3.3) + (0.5*12) = 0.77+1.0725+6 = 7.8425%

Thus Cost of capital for the company is 7.8425%