Question

Using Exhibit A Current Selected Financial Information For XYZ Yield to maturity 10.00% Market Value of debt $500 million Number of shares of common stock 30 million Market price per share of common stock $60 Cost of capital if all equity-financed 11.3% Margin tax rate 40%

19. Based on Exhibit A, ABC is best described as currently ____% debt financed and _____equity financed.

20. Based on Exhibit A, current cost of equity capital is closest to:

Answer 1

Question 19: Value of debt - $500 Million

Value of Equity = Number of shares 8 price per share

= 30 Million * 60

Value of Equity = 1800 Million

So, ABC Debt Percentage = Debt / (Debt + Equity)

= 500 / (500+1800)

= 500 / 2300

= 21.73% or 0.2173

ABC Equity finance = Equity / (Debt + Equity)

= 1800 / (500+1800)

= 1800/2300

= 78.26% or 0.7826

Question 20,

Cost of equity (Unlevered) = 11.3%

Cost of Debt - 10%

Taxes - 40%

Debt - 21.73%

Equity - 78.26%

So, To calculate the cost of equity when the firrm is leverage that is with compenent, by using Modigilani Miller Proposition 2 which is given by,

Ke = Ka + (Kd -Ka)* (D/E)* (1-t)

where, Ke is cost of levered equity

Ka is cost of equity unlevered (All-equity financed)

Kd is cost of debt

D is debt and e is equity

t is taxes

So, Ke = 11.3% + (11.3%-10%)* 21.73%/78.26%* (1-40%)

Ke = 11.3% + 1.3%* 0.27766* (1-0.4)

=11.3% + 1.3%* 0.27766* (0.6)

= 11.3% + 0.21657%

= 11.516 % (Approximately)

Therefore, the cost of levered equity Which is when the company is debt financed also, is 11.516% Approximately.