Question

1. A firm with no debt decides to issue debt. Which of these is false?

A. The firm is better off staying debt free

B. The action should provide a higher return to the equity holders

C. The cost of debt is lower than the cost of equity

D. The cost of debt might sometimes be higher than the cost of equity

E. This is a mistake if the firm cannot invest the proceeds in projects that return a higher rate of return than the adjusted Weighted Average Cost of Capital.

2. A company has a 6% after-tax cost of debt and debt represents 40% of the company’s capital structure. Its weighted average cost of capital is 13%. What is its cost of equity?

A. 19%

B. 13%

C. 17.7%

D. 14.5%

E. 16.8%

3. A firm’s WACC is 20%, its required return on equity is 23%, and its after-tax cost of debt (i.e., effective cost after tax deductions) is 6%. What proportion of the firm’s capital structure is debt, and what proportion is equity?

A. 44.9% debt, 70.9% equity

B. 80.5% debt, 24.1% equity

C. 51.5% debt, 48.5% equity

D. 19.1% debt, 80.9% equity

E. 17.6% debt, 82.4% equity

Answer 1

Answer 1
The statements 'A' and 'C' are false.
Answer 2
Calculation of cost of equity
Weighted average cost of capital = [Weight of equity x Cost of equity] + [Weight of debt x Cost of debt]
Let us assume cost of equity be E.
13% = [0.60 x E] + [0.40 x 6%]
0.13 = 0.60E + 0.024
0.60E = 0.106
E = 0.177
Cost of equity = 17.7%
The answer is Option C.
Answer 3
Calculation of proportion of debt and equity in capital structure.
Let us assume proportion of debt be D , therefore proportion of Equity = 1-D
Weighted average cost of capital = [Weight of equity x Cost of equity] + [Weight of debt x Cost of debt]
20% = [(1-D) x 23%] + [D x 6%]
0.20 = [0.23 - 0.23D] + 0.06D
0.20 = 0.23 - 0.17D
0.03 = 0.17D
D = 0.176
Hence, Proportion of debt = 17.6%
Proportion of equity = 1 - 0.176 = 0.824 i.e.82.4%
The answer is Option E.