Question

A US manufacturing company has reached an EBIT of USD 500 mil. and paid USD 170 mil. in taxes last year. The Debt/Total Capital ration has been 25% (debt in the form of corporate bonds). The company is targeting a constant D/Capital ratio in the future. US 30-year T-Bond's current rate of return is 3%, the average excess return of the US stock market over the last 50 years is 5%. The beta of assets for the firm is 1.1 while the beta of debt equals 1.3. Estimate the weighted average cost of capital for this company. Describe in words what would happen to the company's cash flow and cost of capital if the company decided to raise the level of debt to 50% by taking a bank loan.

Answer 1

Given,

Rf = 3%

Rm - Rf = 5%

Beta of the asset = 1.1

Beta of the debt = 1.3

Cost of Equity (ke) = Rf + (Rm - Rf ) = 3% + 5% * 1.1 = 8.5%

Cost of debt(before tax) = Rf + (Rm - Rf ) = 3% + 5% * 1.3 = 9.5%

Tax rate = $170M / $500M *100 = 34%

Cost of debt(after tax) (kd)= 9.5% * (1- 0.34) = 6.27%

Debt to total capital ratio = 25%

Weight of Debt (Wd) = 0.25

Weight of Equity (We) = 0.75

Weighted Average Cost of Capital (WACC) = We * ke + Wd * kd = 0.75 * 8.5% + 0.25 * 6.27% = 7.94%

When company decided to raise the debt to 50%,

Debt to total capital ratio = 55%

Weight of Debt (Wd) = 0.50

Weight of Equity (We) = 0.50

Weighted Average Cost of Capital (WACC) = We * ke + Wd * kd = 0.50 * 8.5% + 0.50 * 6.27% = 7.39%

Thus if the debt is increased to 50%, the WACC of the company reduces. This is because, the cost of debt is less than the cost of equity and the more we use the less costly debt the lower would be the WACC of the company.

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