Question

Ignacio, Inc., had after-tax operating income last year of $1,197,000. Three sources of financing were used by the company: $2 million of mortgage bonds paying 4 percent interest, $4 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
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

1. Calculate the after-tax cost of each method of financing.

SL No	PARTICULAR	AFTER TAX COST
1	Mortgage bonds	Kd = rate*(1-t)   = .04*(1 - 0.30)= .04*.70=   .028
2	Unsecured bonds	Kd = rate*(1-t)   = .06*(1- 0.30)= .06*.70=   .042
3	Common stock	Ke = Rf + Risk Premium = .03+.08= .11

1. Calculate the weighted average cost of capital for Ignacio, Inc.

SL No	PARTICULAR	WACC=COST *WEIGHT
1	Common stock	= 0.11 *   9     (2+4+9) =.066
2	Unsecured bonds	= 0.042 *   4     (2+4+9) =.0112
3	Mortgage bonds	= 0.028 *   2     (2+4+9) =.0037
WACC		.0809 OR   8.09%

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

$15 million

1. Calculation economic value added (EVA) for Ignacio, Inc., for last year.

EVA = Net Operating Profit After Tax - (Capital Invested x WACC)

= $1,197,000 – ($15000000* 8.09%)

= $1,197,000 -$1335000

= - $138000

Yes the company is destroying wealth since EVA is Negative.

1. If Ignacio, Inc., had common stock which was less risky than other stocks and commanded a risk premium of 5 percent, then weighted average cost of capital would be lower than current WACC i.e 8.09 %

And then WACC would be =0.048+.0112+0.0037 = 0.0629 or 6.29% only

And Revised EVA = $1,197,000 – ($15000000* 6.29%)

= $1,197,000 -$943500

= $253500 showing Positive EVA so it will create wealth.