Question

"The Bold and Beautiful company has 5 million shares outstanding, now trading at £30 per share. The firm has estimated the expected rate of return to equity at 8%. It has also issued long-term debt securities at an interest rate of 6%. Assume that this firm has issued a £100 million bond.

a. What is firm's WACC?

b. If the firm pays tax at a marginal rate of 30%, what is its after-tax WACC? 

c. Briefly discuss the Modigliani-Miller propositions with regard to capital structure. Under what conditions do they hold?

Answer 1

Value of equity = Number of share x price of share

                           = 5 x 30

                           = 150 million

Value of bond=100 million

 

Part A

Cost of equity = 8%

Cost of debt = 6%

WACC = Weight of debt x cost of debt + weight of equity x cost of equity

WACC = 6 x 100/(100+150)  + 8 x 150/(100+150)=7.2%

WACC of the firm = 7.2%

 

Part B

Tax = 30%

WACC = 6(1-0.3) x 100/250 +8 x 150/250

             = 6.48%

WACC of firm = 6.48%

 

Part C

Cost structure have no impact on the value of firm as long as certain condition are relevant. If theses conditions are met than capital structure that means how much is equity and debt have no impacts on the value of the firm. That is capital irrelevance proportion of MM theory.  Following condition to be met so that above theory hold true and relevant.

1. There are no taxes and no transaction cost exist there.

2. Borrowing cost is one and same for all.

3. No tax on dividends exist there.

4. No flotation cost exist there.

5. There is no impact of debt on earning of the firm.

Part A

WACC of the firm = 7.2%