Question

6. Mill Co. is considering to change its current capital structure (30% debt vs. 70% equity) to new capital structure (50% debt vs. 50% equity). The 10-year T-Note is 2%and MRP is 6%. Its current cost of equity is 11%.

What would Mill Co.'s NEW cost of equity be if Mill Co. decides to adapt new capital structure? Assume tax rate to be 25%.

1) 9.87%
2) 13.94%
3)10.65%
4) 11%

15. Mill Co. wants to estimate its WACC Based on the information below, what is its WACC?

26-year, 7.5% annual coupon bonds and sells for $920. (semi-annually compounding)

The risk-free market rate is 6%
The market risk premium is 5%
The stock's beta is 2.
The company's tax rate is 25%

The company's target capital structure consists of 70% equity and 30% debt.

The company uses the CAPM to estimate the cost of equity and does not include flotation costs as part of its cost of capital.

1. 13.06%
2. 10.56%
3. 12.37%
4. 9.89%
5. 8.98%

Answer 1

6. Without solving we can know from options that the answer will be 13.94%. This is due to the fact that as debt increases, the risk increases for shareholders and they would require more return for undertaking risk. With 30% debt, cost of equity was 11%. WIth higher debt (50%) the asnwer has to be more than 11%. Only one option qualifies. Nevertheless, we would solve it mathematically.

According to Modigliani Miller Prospoition with Corporate taxes,

Rs = Ro + (Debt/Equity) * (1-tax) * (Ro-Rb)

where Rs is required return on equity with given Debt/equity

Ro is return on equity for unlevered firm (when debt is zero)

Rb is rate of interest of debt (2% here)

We are given that when Debt/Equity is 30/70 then cost of equity (Rs) is 11%

Calculation of Ro (cost of equity of unlevered firm)

Thus, 11 = Ro + (30/70) * (1-0.25) * (Ro - 2)

Thus, Ro = 8.82%

Calculation of Rs (when debt/equity is 50/50)

Rs = 8.82+(50/50)*(1-0.25)*(8.82-2)

Rs = 13.94%

Cost of equity under new debt/equity structure will be 13.94%

Correct option is 2. 13.94%

15. According to CAPM,

Re = Rf + Beta*(Rm-Rf), where Re is cost of equity, Rm is market return and Rf is risk free return

Rm-Rf is called market risk premium

Re = 6 + 2*5= 16%

Thus cost of equity is 16%

Calculation of debt interest

We can use Excel function =rate(26,75,-920,1000) = 8.26%

26 is number of periods

7.5% coupon rate on $1000 is $75 annual payments

920 is price today. We write negative as it is cash outflow today and others are inflow.

1000 is future value we get (par value)

Thus cost of debt is 8.26%

Calculation of WACC

WACC = (%debt)*(Cost of debt)*(1-tax) + (%equity)*(cost of equity)

WACC = 0.30*8.26*(1-0.25) + (0.70*16)

WACC = 13.06%

Thus, the wacc is 13.06% . Correct option is 1