Question

Case One

Asus Company issued capital for $1,400,000 to start its new project. It issued bonds for $800,000 and acquired the remaining capital from common equity. Asus bond’s YTM is 12.5% and its common stock beta (β) is 1.5. Knowing that the risk free ( is 5% and market risk premium (MRP) is 6% and Taxes are 40%.

Questions 1→5 refers to Case One.

1. Asus weight of debt is:

A.$800,000

B.12.5%

C.57.14%

D.42.86%

2. Asus weight of common equity is:

A.11.00%

B.42.86%

C.57.14%

D.$600,000

3. The after-tax cost of debt for Asus is:

A.12.5%

B.5.0%

C.7.5%

D.6.0%

4. The cost of common equity for Asus is:

A.14.0%

B.13.5%

C.12.5%

D.11.0%

5. The Weighted Average Cost of Capital (WACC) for Asus is:

A.21.50%

B.10.29%

C.10.75%

D.100.00%

Answer 1

Solution:

1.Calculation of Weight of debt of Asus :

The formula for calculating the weight of debt is

= Value of Debt / ( Value of common equity + Value of Debt )

As per the information given in the question we have

Value of Debt = $ 800,000 ;   

Value of common equity = Total Issued capital – Value of Debt

= $ 1,400,000 - $ 800,000 = $ 600,000

Applying the above information in the above formula we have weight of debt as

= $ 800,000 / ( $ 800,000 + $ 600,000 )

= $ 800,000 / $ 1,400,000

= 0.5714

= 57.14 %

Thus the Weight of debt of Asus = 57.14 %

The solution is Option C.57.14 %

2.Calculation of Weight of common equity of ASUS:

The formula for calculating the weight of common equity is

=Value of Common equity / ( Value of common equity + Value of Debt )

As per the information given in the question we have

Value of Debt = $ 800,000 ;   

Value of common equity = Total Issued capital – Value of Debt

= $ 1,400,000 - $ 800,000 = $ 600,000

Applying the above information in the above formula we have weight of common equity as

= $ 600,000 / ( $ 800,000 + $ 600,000 )

= $ 600,000 / $ 1,400,000

= 0.4286

= 42.86 %

Thus the Weight of common equity of Asus = 42.86 %

The solution is Option B. 42.86 %

3.Calculation of after tax cost of debt for Asus :

The formula for calculating the after tax cost of debt is

After tax cost of debt = Kd * ( 1- t )

As per the information given in the question we have

Kd = 12.5 %    ;    t = 40 % = 0.40

= 12.5 * ( 1 - 0.40 )

= 12.5 * 0.60

= 7.5 %

Thus the after tax cost of debt = 7.5 %

Thus solution is Option C = 7.5 %

4.Calculation of cost of common equity for Asus :

Cost of Common equity as per Capital Asset Pricing Model is calculated using the following formula :

RE = RF + [ β * ( RM - RF ) ]

Where

RE = Cost of Common equity    ; RF = Risk free rate of return   ; β = Beta of the stock ;

( RM – RF ) = Market risk Premium

As per the information given in the question we have

RF = 5 %   ; ( RM - RF ) = Market Risk Premium = 6 %   ;   β = 1.5

Applying the above values in the formula we have

= 5 % + ( 1.5 * 6 % )

= 5 % + 9 % = 14 %

Thus the cost of Common equity = 14 %

The solution is Option A. 14.0 %

5.Calculation of Weighted Average Cost of Capital (WACC) for Asus :

The formula for calculating the weighted average cost of capital is =

WACC = [ Ke * We ] + [ Kd * Wd ]

Ke = Cost of equity ; We = Weight of equity ; Kd = After tax Cost of debt  ;   Wd = Weight of debt

As per the information available in the question we have

Ke = 14 % = 0.14   ; We = 0.4286 ;   Kd = 7.50 % = 0.075 ; Wd = 0.5714

Applying the above values in the formula we have

= [ 14 * 0.4286 ] + [ 7.50 * 0.5714 ]

= [ 6.0004 + 4.2855 ]

= 10.2859

= 10.29 ( when rounded off to four decimal places)

Thus the Weighted Average Cost of Capital (WACC) for ASUS is = 10.29 %

The solution is option B. 10.29 %