Question

X Co is identical in all operating and risk characteristics to Y Co, except that X Co is financed only by equity valued at RM3m whereas Y Co has debt valued at RM0.9m (based on market value as part of its capital structure. X Co ad Y Co operate in a country where tax is payable at 33%. The interest paid on Y Co’s debt is RM72,000 per annum, and it pays a dividend to shareholders of RM378,000 per annum. X Co pays an annual dividend of RM450,000.

Required:

(a) Calculate the value of equity of Y Co.

(b) Calculate the cost of capital for X Co.

(c) Calculate the cost of equity for Y Co, and the cost of debt for Y Co.

(d) Calculate the weighted average cost of capital for Y Co.

Answer 1

a) To calculate equity value we need Share Price and no. of shares outstanding. We don't have the required data for the same.

Since, both the companies are identical in all operating and risk characteristics we can assume both have equal capital. X Co have RM 3,000,000 in equity as its capital. So, Y Co will have RM 3,000,000 in capital split into RM 900,000 in debt and RM 2,100,000 in equity.

Value of equity of Y Co = RM 2.1 M

Note: If the answer is wrong please provide more info. It is a bit of stretch without complete data.

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b) Since, X Co is financed only by equity, cost of equity will be the cost of capital for X Co.

Cost of equity = (Annual Dividends for next year   Market Value of Equity) + Growth rate of dividends.

Assumption: Due to lack of information in the question we can assume that dividends for next year will be same as the current dividend and growth rate will be 0.

Cost of equity = (450,000   3,000,000) + 0% = 15%

So, cost of capital for X Co is 15%

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c)

Cost of equity = (Annual Dividends for next year   Market Value of Equity) + Growth rate of dividends.

Assumption: Due to lack of information in the question we can assume that dividends for next year will be same as the current dividend and growth rate will be 0.

Cost of equity = (378,000 2,100,000) + 0% = 18%

Before tax cost of debt of Y Co = Interest Expense Market Value of Debt

= 72,000   900,000 = 8%

After tax cost of debt of Y Co = 8% (1- 33%) = 5.36%

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d)

WACC for Y Co = Weight (Equity) x Cost of Equity + Weight (Debt) x After tax cost of debt

Weight of Equity = 2,100,000 3,000,000 = 0.70

Weight of Debt = 900,000 3,000,000 = 0.30

WACC = 0.70 x (18%) + 0.30 x (5.36%) = 14.21%