Question

Calculating Weighted Average Cost of Capital and Economic Value Added (EVA)

Ignacio, Inc., had after-tax operating income last year of $1,196,000. Three sources of financing were used by the company: $1 million of mortgage bonds paying 4 percent interest, $5 million of unsecured bonds paying 6 percent interest, and $9 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	fill in the blank 1
Unsecured bonds	fill in the blank 2
Common stock	fill in the blank 3

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.

fill in the blank 4 %

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

$ fill in the blank 5

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

$ fill in the blank 6

Is the company creating or destroying wealth?

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?
Lower

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.

$ fill in the blank 9

Answer 1

1. Calculation for the after-tax cost of each method is:

Mortgage = Bonds paying percentage * (1- Tax rate percentage)

=4%*(1-30%)

=4/100*(1-30/100)

=0.028

Unsecured Bonds Paying = Unsecured bonds paying percentage*(1- Tax rate percentage)

=6%*(1-30%)

=6/100*(1-30/100)

=0.042

Common Stock = Risk Premium+ Long term Treasuries rate

=8%+3%

  = 8/100+3/100

=0.110

2. Calculation for a weighted average cost of capital is:

= (Mortgage bonds* cost after-tax)+(Unsecured bonds*cost after-tax)+(Common stock* cost after-tax)

Mortgage bonds+ Unsecured bonds+ common stock

=(1 Million*0.028)+(5 Million*0.042)+( 9 Million*0.110)

1 Million+ 5 Million+ 9 Million

=0.08186

3. Calculation for economic value added:

=After-tax operating Income - [ (Mortgage bonds+ Unsecured bonds+ Common stock) * Weighted average cost)]

=1,196,000 -[ (1,,000,000+5,000,000+9,000 ,000) *0.08186]

=31,900

4. Calculation for the revised EVA is:

=After-tax operating Income - [ (Mortgage bonds+ Unsecured bonds+ Common stock) *Weighted average cost )]

=1,196,000 -[ (1,,000,000+5,000,000+9,000 ,000) *0.06386]

=$238,100

Working Note:

Calculation for revised weighted average is:

=(1 Million*0.028)+(5 Million*0.042)+( 9 Million*(0.3+0.5))

1 Million+ 5 Million+ 9 Million

=0.06386