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
Unsecured bonds
Common stock

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.

%

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

$

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

$

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.

$

Answer 1

Answer:-

Details Given in the Question:-

1. after tax operating Income of PY (NOPAT)- $1,195,500

2. 4% Mortgage bonds - $1 million

3. 6% unsecured bonds - $4 million

4. Common stock – $11 million (Risk premium = 8 % , Risk free rate = 3%)

5. Marginal tax rate = 30%

Answer to Part –I:-

Formula for calculating the after Tax cost of debt = Interest rate (1 – Tax rate)

Formula for calculating the after tax cost of common stock = Risk free rate + Risk Premium

Concept:- In case of bonds, the interest rate is multiplied by (1- tax rate) because the company will have the tax saving on the finance cost i.e. in simple words we can say that the finance cost is the deductible expense due to which profits of the company gets reduced and company needs to pay the tax on the lower amount.

Common stock holders didn’t get any fixed return on their investment and if any amount is paid as dividend to the common stock holders then the same is an appropriation of profits and not a deductible expense so there is no impact of taxation on the same.

For example:- If company has Gross profit of let say $100 and have 10% loan of $300 then the company has finance cost of $30 (10% of $30). So, net profit will be $70 ($100 - $30). So company is required to pay the tax on $70 only & let say tax rate is 30% so the tax amount will be only $21($70*30%). Now think as if there will be no finance cost then company needs to pay the tax on $100 and tax will be $30 ($100*30%) so due to the finance cost of $30 there is a tax saving of $9 ($30*30%). So the effective finance cost will be “Gross Finance cost – Tax saving due to finance cost” i.e. ($30 - $9 = $21). In order to find out the after tax rate we will divide the effective finance cost with the amount of finance. i.e. ($21/$300) so effective after tax rate will be 7%.

a) After tax cost of Mortgage Bonds :- 4(1-30%) = 2.80%

b) After tax cost of Unsecured Bonds :- 6(1-30%) = 4.20%

c) After tax cost of common stock :- 3% + 8% = 11%

Answer to Part –II

Weighted average cost of capital (WACC) represents the cost of capital across all sources. The cost bear by the company on the funds utilized by the company in their business.

Formula:-

WACC = Value of common stock/Total value of finance * after tax cost + Value of debt/Total Value of Finance * after tax cost

Working Notes:-

i. Weights of Mortgage Bonds = Value of mortgage bonds/ Total value of Finance

= $1//($11 million + $4 million + $1 million)

= 0.0625

ii. Weights of Unsecured Bonds = Value of unsecured bonds/ Total value of Finance

= $4//($11 million + $4 million + $1 million)

= 0.25

iii. Weights of Common stock = Value of common stock / Total value of Finance

= $11 million /($11 million + $4 million + $1 million)

= 0.6875

WACC = Weight of common stock * Cost of common stock + Weight of Mortgage Bonds * after tax Cost of Mortgage bonds + Weight of unsecured bonds * Cost of unsecured bonds

WACC = 0.6875*11 + 0.0625*2.80 + 0.25*4.20

         = 7.5625 + 0.175 + 1.05

         = 8.79%

Total dollar amount of capital employed for Ignacio, Inc = $11 m + $4m +$1m = $16million

Answer to Part- III

Economic value Added(EVA):- It is the profit earned by the company over and above the cost of funds utilized by the company. i.e. How much extra the company earn after deducting its cost of capital or we can say how much of the value of increases. It is used for measuring the financial performance of the company.

EVA = NOPAT – (WACC* Capital Invested)

     = $1,195,500(as given in the question) – (8.79% * $16 million)

     = $1.1955 million – $1.4064 million

= ($0.2109 million)

If the EVA of the company is negative then it means company is not generating any value from the funds invested into the business. In simple words the company is not earned sufficient after tax operating profits which can cover its funding costs. Hence, the company is destroying its wealth.

Answer to Part - IV

If the risk premium is 5% then after tax cost of common stock will be = (5% + 3% = 8%), then according the WACC will be

WACC = Weight of common stock * Cost of common stock + Weight of Mortgage Bonds * after tax Cost of Mortgage bonds + Weight of unsecured bonds * Cost of unsecured bonds

WACC = 0.6875*8 + 0.0625*2.80 + 0.25*4.20

         = 5.5 + 0.175 + 1.05

         = 6.73%

Note:- Weights would remain same & cost of Mortgage & unsecured bonds remains same.

Due to the lower risk premium the WACC of the company is reduced from 8.79% to 6.73%.

Reason :- Since the stocks become less risky as compared to the other stocks and there is a principle of “less risk less return” so the investors are not expecting the higher return on the company’s common stock due to which the WACC got reduced with the reduction in risk premium.

New EVA will be

EVA = NOPAT – (WACC* Capital Invested)

       = $1,195,500(as given in the question) – (6.73% * $16 million)

       = $1.1955 million - $1.0768 million

       = $ 0.1187 million       

Due to the reduction in the WACC, the EVA becomes positive and we can say the company is creating the wealth and more specifically company has create the wealth of $0.1187 million in the previous year.