Question

Ali Baba & Co. is a small company engaged in the hospitality industry. The cost of debt capital is 10%; EBIT is $150; the amount of debt is $500; the cost of unlevered debt is 20%; and the tax rate is 34%.

a. Calculate the value of Ali Baba & Co’s equity. (show your calculations in detail)

b. Calculate the cost of equity capital for Ali Baba & Co.   

c. Calculate the WACC for Ali Baba & Co.

d. What do you conclude?

Answer 1

Answer of question a:

Value of unlevered firm = EBIT / Ke x 100

Ke= Cost of Equity.=20%

EBIT= 150

Cost of unlevered firm = 20 % (It will be considered cost of equity)

Value of unlevered firm = 150/ 20 X 100 = $ 750/-

Value of Levered firm = Value of unlevered firm

Add: Value of Debt = --------------------------------

Value of unlevered firm = 750

Add: Value of debt = 500   

Value of levered Firm    1250

  

Answer to question b: Cost of equity shall be the cost of unlevered firm which is 20%.

Answer to question c: Computation of WACC

S.No	Fund Source	Amount	Weights	Specific cost	Weighted average cost (Weights X Specific cost)
1	Equity	750	750/1250 =.60	20%	12
2	Debt	500	500/1250 = .40	6.60 %	2.64
	Total	1250			14.64 %

WACC= 14.64 %

Computation of cost of debt after tax:

Interest rate= 10 %

Tax Rate = 34 %

cost of debt: I(1-t)

I= Interest Rate

t = Tax Rate

cost of debt: I(1-t) = 10(1- .34)   = 6.60 %

Note: When 34% will be converted into normal figure it will come .34 ( 34/100= .34 )

Answer to question d:

In conclusion it can be said that if company wants to increase its earning per share & wants to redoce its tax liability it should include more debt in its capital structure.