Question

Ignacio, Inc., had after-tax operating income last year of $1,195,500. 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 (Value)

Unsecured bonds (Value)

Common stock (Value)

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.

(Percentage) %

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

$ (Value)

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

$ (Value)

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.

$ (Value)

Answer 1

	1) Calculation of payout of each method of Finance:
	Rate of dividend on common stock = risk free rate + risk premium
	= 0.03+0.08 = 0.11 i.e. 11%
		Particulars	Amount (Financed)	Dividend / Interest	After Tax Cost in amount	After tax Cost of capital
		(a)	(b)	(c)	(d)	(e)
		Mortgage Bond	1,000,000	40,000	28,000	0.028
				(1,000,000 X 4%)	(40000 X 0.7)	(28000/1000000)
		Unsecured Bond	4,000,000	240,000	168,000	0.042
				(4,000,000 X 6%)	(240000 X 0.7)	(168000/4000000)
		Common Stock	11,000,000	1,210,000	1,210,000	0.11
				(11,000,000 X 11%)		(1210000/11000000)
	2	Calculation of weighted average cost of capital:
		Particulars	Amount (Financed)	Weight	After Tax Cost in amount	After tax Cost of capital	Weighted average cost (WACC)
		(a)	(b)	(c)	(d)	(e)	(f = e*c)
		Mortgage Bond	1,000,000	(1/16)	28,000	0.028	0.00175
		Unsecured Bond	4,000,000	(4/16)	168,000	0.042	0.0105
		Common Stock	11,000,000	(11/16)	1,210,000	0.11	0.0756
		Total	16,000,000				0.0879
		Therefore, weighted average cost of capital is 0.0879 i.e. 8.79%
	3	Economic Value Added:
		EVA = NOPAT - (WACC* Capital employed)
		EVA = 1,195,500 - (0.0879*16,000,000)
		EVA = (210,900)	-210900
		As the EVA figure is negative, company is destroying the wealth of the investors instead of creating it.
	4	If the company's common stocks were less risky and had commanded only 5% risk premium, then,
		Rate of dividend on common stock = risk free rate + risk premium
		= 0.03+0.05 = 0.08 i.e. 8%
		Calculation of weighted average cost of capital:
		Particulars	Amount (Financed)	Weight	After Tax Cost in amount	After tax Cost of capital	Weighted average cost (WACC)
		(a)	(b)	(c)	(d)	(e)	(f = e*c)
		Mortgage Bond	1,000,000	(1/16)	28,000	0.028	0.0018
		Unsecured Bond	4,000,000	(4/16)	168,000	0.042	0.0105
		Common Stock	11,000,000	(11/16)	1,210,000	0.08	0.0550
		Total	16,000,000				0.0673
		Therefore the company's WACC would have been = 0.0673 i.e. 6.73%
		EVA would have been = 1,195,000 - (0.0673*16,000,000)
		118200
		Conclusion:If the company's stock been less risky, company would have created a positive economic value added for its investors.