Question

Harris Inc., has equity with,a market value of $23.2 million and debt with,a market value,of $11.6 million . Treasury bills that mature in one year yield 4 percent per yearband the,expected return on the market portfolio is 10 percent. the beta of the,company's equity is 1.17. The company pays no taxes.

a. Debt-equity ratio=
b. Weight,average cost of capital=
c. Cost of capital=

Answer 1

Solution:
a.	Debt-equity ratio	0.50
Working Notes:
	Debt-equity ratio
	= Market value of Debt /Market value of Equity
	=$11.6 million/ $23.2 million
	=11.6/23.2
	=0.50
b.	Weight average cost of capital (WACC)	8.68	%
Working Notes:
	Cost of equity Ke using CAPM
	Ke= Required return of stock =??
	B= Beta of the stock = 1.17
	rf= risk free rate = 4 %
	rm = expected return for the market = 10%
	Ke = rf + (rm-rf) x B
	Ke = 4% + (10%-4%) x 1.17
	Ke = 4% + 7.02%
	Ke = 11.02%
	Using Modigliani-Miller theorem , company debt is risk free and we use T bill rate as cost of debt Kd = 4%
	As there company does not pay taxes , so tax is ignored below:
	After tax cost of debt (Kd) = Cost of debt = 4%
	Cost of common equity (Ke)=11.02%
	Debt equity ratio =0.50 means Debt = 0.50 of Equity
	where , Value of Equity E= 1
	Value of Debt D= 0.50
	Total Value of Capital Structure = E + D = V =1+ 0.50 = 1.50
	WACC= Ke x E/V + Kd   x D/V
	WACC = 11.02% x (1/1.50) + 4% x (0.50/1.50)
	=8.68%
c.	Cost of capital	8.68	%
Working Notes:
	Using M&M Proposition II without taxes
	RS = R0+ (R0-RB)(B/S)
	Where
	B/s = debt equity ratio =0.50
	RS is cost of equity capital = 11.02 %	calculated in a.
	R0 is cost of equity capital of unlevered firm = ??
	RB is Cost of Borrowing = 4%
	RS = R0+ (R0-RB)(B/S)
	11.02% = R0+ (R0-4%)(0.50)
	11.02% = R0+ 0.50 x R0 - (4% x 0.50)
	11.02% = R0+ 0.50 R0 - 2%
	13.02% 1.50 x R0
	R0 = 13.02% /1.50
	R0=8.68%
Please feel free to ask if anything about above solution in comment section of the question.