Question

Consider Aquarius, an all-equity firm in the Consumer Staples industry. Aquarius’s management estimates that the company’s earnings before interest and taxes (EBIT), currently at $600,000, will remain constant for the foreseeable future. The company has an estimated asset beta of 1.32 and a marginal corporate tax rate of 30%. Given that 3-month Government of Canada treasury bills have a return of 2.00% and the expected market return is 9.68%, solve the following problems under the assumptions.

Case I: Assume world with no corporate or personal taxes and no financial distress costs.

a) What is Aquarius’s weighted average cost of capital of capital (WACC)? What is its value?

b) What would be Aquarius’s value and WACC if the company decides to use debt with a market value of $2,400,000 to generate the same EBIT? (Assume Aquarius can borrow at the risk-free rate).

c) Describe the following:

1. The relationship between financial leverage (D/E ratio) and cost of equity (RE).

2. The relationship between financial leverage and the overall cost of capital (WACC)

3. The relationship between financial leverage and the value of the firm.

Case II: Assume world with corporate taxes but no financial distress costs

d) What is Aquarius’s WACC if the firm is all-equity financed. What is its value?

e) What would be Aquarius’s value and WACC if the company decides to use debt with a market value of $2,400,000 to generate the same EBIT? (Assume Aquarius can borrow at the risk-free rate).

f) Describe the following:

1. The relationship between financial leverage (D/E ratio) and cost of equity (RE).

2. The relationship between financial leverage and the overall cost of capital (WACC)

3. The relationship between financial leverage and the value of the firm.

Case III: Assume world with corporate taxes and default risk

As default risk is present, Aquarius’s borrowing rate varies with financial leverage as indicated in the following table:

Value of Debt	Rd	Beta	Re	Value of Equity	Value of Firm	WACC
-	2.00%	1.34
400,000	2.00%	1.42
800,000	2.40%	1.58
1,200,000	3.00%	1.77
1,600,000	4.20%	2.05
2,000,000	6.70%	2.32
2,400,000	8.90%	3.21

g) Complete the above table.

Answer 1

Cost of equity,Ke= Rf + Beta*(Rm-Rf)

= 0.02+1.32*(.0968-.02) = 0.1213= 12.13%

Since its a all equity firm, therefore debt is zero.

Hence, Value of equity= EBT/ Ke= 600000/0.1213= $49,46,413.84

Hence, Value of the firm is also same as value of equity as the company is all equity firm.

a.) Therefore, V= $ 49,46,413.84

Cost of capitol, Ko= EBIT/Value of firm= 600000/49,46,413.84 = 12.13%

b.) Debt= 2,400,000 and Cost of debt, Ke= 2%

Interest = .02*2400000= $48000

EBT= 600000- 48000= $ 552000

Value of equity= EBT/ Ke= 552000/.1213= $ 4550700

Value of firm, V= 4550700+2400000= $6950700

Ko= (E/V)* Ke+ (D/V)* Kd*(1-t)

= (4550700/ 6950700)* .1213 + (2400000/6950700)* .02* (1- .3)

= 0.079+ 0.004= 0.083= 8.3%

c.)

1. More is the debt then more will be the interest to be paid by the company and lesser will be the EBT. Therefore, cost of equity will reduce.

2. More is the Debt-Equity ratio then more will be the debt of the company. This in return will lower the cost of capitol employed the company, hence is good for making more profit. But more debt will raise the financial risk as well.

3. Value of firm is the combination of total debt and equity of a company. If a company is growing then more debt will increase the profit and will increase the value of the firm. But if the firm is unable to meet the debt obligations then the value of the firm will fall.