Question

Answer each of the following questions. pls TYPE answers showing the calculation processes, not taking a picture of handwriting.

1. BD has 35,000 bonds outstanding that trade at par value (each bond has a par value of $1,000). Companies with similar characteristics have their bonds trading at a yield of 4.5%. The company also has 5 million shares of common stock outstanding. The stock has a beta of 1.3 and sells for $25 a share. The risk free rate is 1.5% and the market risk premium is 6%. The company’s tax rate is 30%. What is the company’s weighted average cost of capital?

2. Suppose BD Ltd now wishes to change its capital structure to have a weighted average cost of capital of 6.5%. What equity ratio (equity to total firm value) is needed for the firm to achieve its targeted weighted average cost of capital?

3. Academic theory suggests that a firm’s capital structure should not change firm value. Explain the rational for this argument and then discuss real world issues that may change this conclusion.

Answer 1

Q - 1

D = P x N = 1,000 x 35,000 = 35 million; Kd = YTM = 4.5%: T = 30%

E = P x N = 25 x 5 = 125 million; Ke = Rf + beta x market risk premium = 1.5% + 1.3 x 6% = 9.30%

Wd = D/(D + E) = 35/(35 + 125) = 21.88%

We = 1 - Wd = 1 - 21.88% = 78.13%

Hence, WACC = Wd x Kd x (1 - T) + We x Ke = 21.88% x 4.5% x (1 - 30%) + 78.13% x 9.30% = 7.95%

Q - 2

WACC = (1 - We) x Kd x (1 - T) + We x Ke

Or. 6.5% = (1 - We) x 4.5% x (1 - 30%) + We x 9.30%

Hence, the equity ratio (equity to total firm value) is needed for the firm to achieve its targeted weighted average cost of capital, We = 54.47%

Q - 3

Academic theory suggests that a firm’s capital structure should not change firm value. Explain the rational for this argument

• This academic theory derives its basis for Modigliani & Miller proposition.
• In the absence of taxes, bankruptcy cost, cost of distress and in the presence of perfect market conditions, no trasanction costs; the value of the firm is indeed independent of capital structure.
• Hence, only when all those asumptions hold true, a firm’s capital structure should not change its value.

Discuss real world issues that may change this conclusion:

However, the real world is full of problems, issues and hence deviate from the assumptions we have made above.

• There are taxes
• There are bankruptcy cost and costs of financial distress due to excessive leverage.
• Markets are not always perfect.
• There are transaction costs
• And because of these reasons, capital structure impact the weighted average cost of capital which in turn impact the valuation of the firm. Hence, in real world the values of the firms are indeed impacted by the capital structure.