Question

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

Ignacio, Inc., had after-tax operating income last year of $1,195,500. 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?

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

1. Calculate the after-tax cost each financing
Mortgage bonds=0.04(1-0.30)= 0.028
Unsecured bonds = 0.06(1-0.30)= 0.042
Common stock= Risk free rate + Risk premium =0.08+0.04=0.12
2. Calculate the weighted average cost of capital Ignacio, Inc.
Pariculars	Value	weight value	cost	WACC
Mortgage bonds	2,000,000	0.125	0.028	0.0035
Unsecured bonds	4,000,000	0.25	0.042	0.0105
Common stock	10,000,000	0.625	0.12	0.075
Total	16,000,000	1		0.089
WACC= 8.9%
Calculate the total dollar amount of capital employed for Ignacio, Inc.
$2000000+$4000000$10000000=$16000000
3. Calculate economic value added (EVA) for Ignacio, Inc
Net income after tax = $1,195,500
Capital invested = $16000000
WACC= 8.9%
Capital invested * cost of capital = $ 1424000
EVA = net income after tax - 1424000
EVA=1195500-1424000= -228500
The company is distroying the wealth
4.Calculate the weighted average cost of capital if the preimum is 5% so cost of comman stock =0.04+0.05=0.09
Pariculars	Value	weight value	cost	WACC
Mortgage bonds	2,000,000	0.125	0.028	0.0035
Unsecured bonds	4,000,000	0.25	0.042	0.0105
Common stock	10,000,000	0.625	0.09	0.05625
	16,000,000	1		0.07025
WACC=7.025%
Calculation of EVA
Net income after tax = $1,195,500
Capital invested = $16000000
WACC= 7.025%
Capital invested * cost of capital = $ 1124000
EVA = net income after tax - 1124000
EVA=1195500-1124000= 71500