Question

Today is beginning-of-year 20X2. rmation on Zircon, a gemstone trading and consulting busin Here is some recent info ess. Balance Sheet for End of Year 20X0 20X1 100.0 Current Assets 100.0 200.0 200.0 net PPE Total Assets 300.0 300.0 Accounts Payable 100.0 50.0 Short Term Debt 50.0 10.0 20.0 Other Current Liabilities 50.0 100.0 100.0 Bonds Maturing in 20X5 230.0 Total Liabilities 250.0 Equity 50.0 70.0 Income Statement for Year 20X1 60.0 Revenue 20.0 COGS and SGA Interest 15.0 Таx 5.0 20.0 Net Income The firm's equity market value is estimated to be the same as its GAAP value.

A. What is the company's cost of debt financing, r_D?

B. What is the company's tax rate?

C. What is the company's weight of debt financing?  

D.What is the company's weight of equity financing?

E. If the company's cost of equity capital, r_E, is 15.0%, what is the firm's WACC?

Answer 1

Given
Liabilities (2000) = (50 + 50 + 50 + 100) = 250 Liabilities (2001) = 100 + 10 + 20 + 100 = 230
Total Liabilities = Liabilities + equity = 250+ 50 = 300 (2001) 230 + 70 = 300 (2002)

Revenue = 60
Total Costs = 20
Profit margin = 60 - 20 = 40
Interest = 15

Profit Before Tax = (40 - 15) = 25

Tax = 5
Net Income = (25 - 5) = 20

A.
Cost of Debt Financing
Debt = (Short term debt + bond (long term debt)) = 50 + 100 (2000)
Interest Paid = 15 (2000-2001)

Cost of Debt = Interest Paid / Debt = 15/150 = 10%

B
Company Tax rate
Profit Before tax = 25
Tax = 5

Tax rate = Tax / Profit Before Tax = 5/25 = 20%

C
Company's weight of debt financing
Total Debt = 150 (2000) 110 (2001
Equity = 50 (2000) 70 (2001)

Weight of debt = 150/(150+50) = 0.75 (2000) 110/(110+70) = 0.61111111 (2001)

We will use 2001 debt ratios as we are computing it on beginning of 2002
0.61111

D

Company's weight of equity financing

Total Debt = 150 110
Equity = 50 70

Weight of equity = (50/ (150+50)) = 0.25 = (70/(70+110)) = 0.388888889
We will use 2001 equity ratios as we are computing it on beginning of 2002
0.388889

E
Cost of equity = 15%
Cost of debt = 10%

Weight of debt = 0.75 (2000)   0.611 (2001)
Weight of equity = 0.25 (2000) 0.389 (2001)

WACC = (Cost of equity * weight of Equity) + (Cost of debt * Weight of Equity)

  = 0.75 * 10% + 0.25 * 15% = 0.6111 * 10% + 0.3889 * 15 %

= 11.25% (2000) = 11.94% (2001)
We will use 2001 WACC as we are computing it on beginning of 2002
11.94%

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