Question

Ignacio, Inc., had after-tax operating income last year of $1,198,000. Three sources of financing were used by the company: $1 million of mortgage bonds paying 4 percent interest, $4 million of unsecured bonds paying 6 percent interest, and $11 million in common stock, which was considered to be relatively risky (with a risk premium of 8 percent). The rate on long-term treasuries is 3 percent. Ignacio, Inc., pays a marginal tax rate of 30 percent.

Required:

1. Calculate the after-tax cost of each method of financing. Enter your answers as decimal values rounded to three places. For example, 4.36% would be entered as ".044".

Mortgage bonds	_______
Unsecured bonds	_______
Common stock	_______

2. Calculate the weighted average cost of capital for Ignacio, Inc. Round intermediate calculations to four decimal places. Round your final answer to four decimal places before converting to a percentage. For example, .06349 would be rounded to .0635 and entered as "6.35" percent.

____ %

Calculate the total dollar amount of capital employed for Ignacio, Inc.

$ ____

3. Calculate economic value added (EVA) for Ignacio, Inc., for last year. If the EVA is negative, enter your answer as a negative amount.

$ _____

Is the company creating or destroying wealth?

(CREATING/DESTROYING)

4. What if Ignacio, Inc., had common stock which was less risky than other stocks and commanded a risk premium of 5 percent? How would that affect the weighted average cost of capital?

(HIGHER/LOWER/UNAFFECTED)

What is the new EVA? In your calculations, round weighted average percentage cost of capital to four decimal places. If the EVA is negative, enter your answer as a negative amount.

$ ______

Answer 1

1

After tax cost of each method of financing

Cm

Mortgage Bond=4%*(1-Tax Rate)=

2.80%

4*(1-0.3)

Cu

Unsecured Bond=6*(1-tax rate)

4.20%

6*(1-0.3)

Cs

Common Stock=Risk free rate+Premium

12%

(4+8)

2

A

Mortgage Bond=

$1

million

B

Unsecured Bond

$5

million

C

Common Stock

$11

million

D

Total

$17

million

Wm=A/D

Weight of Mortgage Bond=

0.06

Wu=B/D

Weight of Unsecured Bond

0.29

Ws=C/D

Weight ofCommon Stock

0.65

Weighted Average Cost of Capital(WACC)

=

Cost of Mortgage Bond*Weight of Mortgage Bond+Cost of Unsecured Bond*Weight of Unsecured bond+Cost of Common Stock*Weight of Common Stock

=

WACC=Cm*Wm+Cu*Wu+Cs*Ws=

8.90%

Weighted Average Cost of Capital

8.90%

Dollar amount of capital employed

$18,000,000

3

Net Operating Income After Tax(NOPAT)

$1,196,500

WACC

8.90%

Capital Invested

$18,000,000

Economic Value Added (EVA)=NOPAT-(WACC*Capital Invested)

EVA=1196500-(8.90%*18000000)=

($405,500.00)

Company is destroying wealth

4

If the risk premium of common stock is 5%

Cs

After tax cost of common stock=(4% + 5%)

9%

WACC=(1*0.028+6*0.042+11*0.09)/(1+6+11)

7.10%

EVA=1196500-(7.10%*18000000)=

$(81,500)