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Corporate Financial Management:The Cost of Capital 12. a. Eve Industries has a target capital structure of...

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%)

  1. Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 per cent. The company also has 750,000 shares of 7 per cent preference shares and 2.5 million shares of ordinary equity outstanding. The preference shares sell for €53 a share. The ordinary equity has a beta of 1.34 and sells for €42 a share. The government Treasury bill is yielding 2.8 per cent and the return on the market is 11.2 per cent. The corporate tax rate is 38 per cent. What is the firm's weighted average cost of capital? (60%)
  1. When firms choose to issue new debt or equity, what will happen to the WACC? Explain, in detail why this is the case.(20%)

Solutions

Expert Solution

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.

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