In: Finance
Corporate Financial Management:The Cost of Capital
12. a. Eve Industries has a target capital structure of 41% ordinary equity, 4% preference shares, and 55% debt. Its cost of equity is 19%, the cost of preference shares is 6.5%, and the pre-tax cost of debt is 7.5%. If the firm has a tax rate of 34%, what is the firm’s Weighted Average Cost of Capital (WACC)? (20%)
Eve Industries | |||||
a) | Tax Rate | 34% | |||
Before tax cost of Debt | 7.5% | ||||
Preferred Stock | 4.0% | ||||
Equity Capital | 19.0% | ||||
After tax cost of debt=7.5%(1-.34) | 0.0495 | ||||
Weighted Average Cost of Capital | |||||
(A) | (B) | (A)*(B) | |||
Capital structure | Cost | WACC | |||
Equity= | 41.00% | 19.00% | 0.0779 | ||
Debt= | 55.00% | 4.95% | 0.0272 | ||
Preferred Stock | 4% | 4.0% | 0.0016 | ||
WACC | 100.00% | 0.1067 | |||
WACC= | 10.6725 | % | |||
Phillips Equipment | |||||
b) | |||||
Risk free rate | 2.80% | ||||
Beta | 1.34 | ||||
expected return on the market | 11.2% | ||||
Cost of Equity=Risk free rate+Beta*(Market rate of return-Risk free rate) | |||||
Cost of Equity=2.80%+1.34*(11.2%-2.80%) | 0.14056 | ||||
Cost of Equity= | 14.056% | % | |||
Return on Preferred stock=(.07*100)/53) | 13.208% | ||||
Tax Rate | 38% | ||||
Before tax cost of Debt | 6.75% | ||||
After tax cost of debt=6.75%(1-.38) | 4.19% | ||||
Weighted Average Cost of Capital | |||||
Debt=(80000*1000)= | $ 8,00,00,000.00 | ||||
Preferred Stock(750000*$53) | $ 3,97,50,000.00 | ||||
Equity(2500000*$42) | $ 10,50,00,000.00 | ||||
Total | $ 22,47,50,000.00 | ||||
Debt %=($80000000/$224750000) | 35.60% | ||||
Preferred Stock %(39750000/$224750000) | 17.69% | ||||
Equity %=($105000000/$224750000) | 46.72% | ||||
(A) | (B) | (A)*(B) | |||
Capital structure | Cost | WACC | |||
Equity= | 46.72% | 14.06% | 0.0657 | ||
Debt= | 35.60% | 4.19% | 0.0149 | ||
Preferred Stock | 17.69% | 13.21% | 0.0234 | ||
WACC | 100.00% | 0.1039 | |||
Weighted Average cost of capital | 10.39 | % | |||
c ) | Weighted average cost of capital is the combination of debt and equity cost. | ||||
When the company's debt equity ratio increases, its weighted average cost of capital decreases. |