Question

 

Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corp. is an unlevered firm, and R Inc. is a levered firm with debt of $5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $2 million and a marginal corporate tax rate of 40%. Q Corp. has a cost of capital of 15%. (20 marks total)

a. What is Q’s cost of equity capital?

b. What is R’s cost of equity capital?

c. What is Q’s WACC?

d. What is R’s WACC?

e. Compare the WACC of the two companies. What do you conclude?

Answer 1

		Q corp		R corp
EBIT		2000000		2000000
less interest-		0		500000
EBT		2000000		1500000
less tax -40%		800000		600000
EAT		1200000		900000
cost of capital		15%
value of equity	EAT/cost of capital	8000000
Value of R corp	value of unlevered firm+ tax rate*amount borrowed	8000000+(.40*5000000)	10000000
Cost of equity - Q -15%
cost of equity - R
RE= RU+ (RU– RD)(D/E)(1 – t)	.15 + (.15-.1)*(10000000/ 8000000)*(1-.4)	18.75%
			weight
total value of equity Q		8000000	100%
value of equity		8000000	100%
value of debt		0	0%
			Weight
value of levered firm		10000000	100%
value of equity	10000000-5000000	5000000	0.5
value of debt		5000000	0.5
Q' s WACC = (weight of debt*cost of debt)*(weight of equity*cost of equity)	(100%*15%)+(0*0.6)	15.00%
R's WACC =   (weight of debt*cost of debt)*(weight of equity*cost of equity)	(.5*18.75%)+(.5*6%)	12.38%
company	Q	R
WACC	15.00%	12.38%
WACC of the R is low due to use of debt in its capital structure