Question

1. How should we estimate the mix of equity and debt in the firm’s capital structure, and what will make it change?

b, How can we combine this information in order to estimate a company’s weighted average cost of capital (WACC), and what does that estimate tell us?

Answer 1

To get the mix of debt and equity
1- First get the market value of debt	no. of Units issued * current market price
2- now we shall get the value of equity	no. of units of common stock issued*current market price
3- to get the total value of corporation add value of debt and value of equity	value of debt + value of equity
proportion of debt in capital structure	value of debt/total value of firm
proportion of debt in capital structure	value of equity/total value of firm
Suppose no of bonds issued are 1000 and market value per bond is 1200 and 10000 common stocks are issued with a market price of 120. after tax cost of debt is 12% while cost of equity is 15% calculate WACC
First we calculate market value of debt	1000*1200	1200000
market value of equity	10000*120	1200000
total value of firm	value of debt+ value of equity =1200000+1200000	2400000
Weight or proportion of debt in capital structure	1200000/2400000	0.5
Weight or proportion of equity in capital structure	1200000/2400000	0.5
These proportions or weights are used to calculate the WACC. While calculating WACC these weights are multiplied with respective cost of source and then summed up to get a WACC
With the continuation of the previous example
Source	weight	cost of source of fund	weight*cost of source
debt	0.5	12%	0.06
equity	0.5	15%	0.075
WACC = sum of weight*cost of source			13.50%
WACC is used as a hurdle rate or minimum required rate of return to assess the capital projects