Question

19. A firm has a cost of debt of 6 percent and a cost of equity of 13.7 percent. The debt–equity ratio is 1.02. There are no taxes. What is the firm's weighted average cost of capital?

20. Hotel Cortez is an all-equity firm that has 5,500 shares of stock outstanding at a market price of $15 per share. The firm's management has decided to issue $30,000 worth of debt and use the funds to repurchase shares of the outstanding stock. The interest rate on the debt will be 10 percent. What is the break-even EBIT?

Answer 1

19

D/A = D/(E+D)

D/A = 1.02/(1+1.02)

=0.505

Weight of equity = 1-D/A

Weight of equity = 1-0.505

W(E)=0.495

Weight of debt = D/A

Weight of debt = 0.505

W(D)=0.505

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 6*(1-0)

= 6

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=6*0.505+13.7*0.495

WACC =9.81%

20

Shares after repurchase = shares-debt/price = 5500-30000/15=3500

Break even EBIT is the EBIT where EPS plan I = EPS plan II

EBIT*(1-tax rate)/shares = (EBIT-interest rate*debt)*(1-tax rate)/shares

EBIT*(1-0)/5500=(EBIT-0.1*30000)*(1-0)/3500

EBIT =8250