Question

7. Prego Corp. has a target capital structure of 30% debt, 60% common equity, and preferred stock of 10%. The yield to maturity on the company’s outstanding bonds is 9%, and its tax rate is 21%. The cost of preferred stock is 5%. Prego’s CFO estimates that the company’s WACC is 9.96%. What is Prego’s cost of equity?

8. If the total capital structure is $90,000,000 and the debt to equity ratio is 50%, what is the dollar amount of debt?

9. Referencing problem 7, what is the dollar amount of equity?

10. Look up the beta for Tapestry, Inc. What is it and what does it mean?

11. If you had to calculate the cost of equity for Twitter, Inc. which way would you have to do it?

12. If a firm’s WACC is 8.00%, what does this mean to the firm?

Answer 1

7. Prego Corp. has a target capital structure of 30% debt, 60% common equity, and preferred stock of 10%. The yield to maturity on the company’s outstanding bonds is 9%, and its tax rate is 21%. The cost of preferred stock is 5%. Prego’s CFO estimates that the company’s WACC is 9.96%. What is Prego’s cost of equity?

Ans

Following assumptions are made

• The cost of debt before tax is 9%
• The tax rate is 21%
• The cost of preferred stock is 5%
• The WACC or weighted average cost of capital is 9.96%
• The weights in WACC for 30% debt ,60% common equity and 10% preferred stock

To calculate the cost of equity. We will use the formula of WACC to calculate the cost of equity as below

WACC = W_d R_d (1-T) + W_p R_p + W_e R_e

Where

W_d = weight of debt which is given 30% or 0.30

R_d = cost of debt before tax is 9% or 0.09

T = tax rate which is 21% or 0.21

W_p = weight of preferred stock which is given 10% or 0.10

R_p = cost of preferred stock which is 5% or 0.05

W_e = weight of common equity which is given 60% or 0.60

R_e = cost of equity to calculate let us put as X

WACC = weighted average cost of capital is 9.96% or 0.0.996

Putting the values in the formula we get

WACC = W_d R_d (1-T) + W_p R_p + W_e R_e

0.0996 = 0.30x0.09(1-0.21) + 0.10 x 0.05 + 0.60 x X

0.0996 = 0.30x0.09(0.79) + 0.005 + 0.60 X

0.0996 = 0.30x 0.0711 + 0.005 + 0.60 X

0.0996 = 0.02133 + 0.005 + 0.60 X

0.0996 = 0.02633 + 0.60 X

0.0996 - 0.02633 = 0.60 X

0.07327 =0.60 X

X = 0.07327 /0.60

X =0.122117 or 12.2117%

The cost of equity for Prego Corp is 12.2117%

8. If the total capital structure is $90,000,000 and the debt to equity ratio is 50%, what is the dollar amount of debt?

Ans

The total capital structure means the sources of funds the company acquires to run its business. In the problem the following capital structure is given

• The total capital structure including debt and equity is $90,000,000
• The debt to equity ratio is 50%

The formula for debt to equity ratio is given below

Debt to equity ratio = total liabilities / shareholder’s Equity

Where

Debt to equity ratio = given 50% or 0.50

Which means debts is 50% of shareholders equity or if share holders equity is 100 than debt will 50

The total capital structure is total of debts and equity which will be 150( 50 + 100)

Equity will be = ($$90,000,000 / 150) x 100

= $ 600,000.00 x 100

= $ 60,000,000.00

The equity in dollar amount will be $60,000,000

9. Referencing problem 7, what is the dollar amount of equity?

Ans

The following information will be taken from problem 7 to calculate dollar amount of equity

• The weight in total capital structure is 60% for equity or 0.60

• The total capital structure is $90,000,000

Equity in dollars = total capital structure in dollars x weight of equity in total capital structure

= $90,000,000 x 0.60

= $ 54,000,000

The dollar amount of equity is $ 54,000,000