Question

Ch 13: Assignment - Capital Structure and Leverage Attempts: Average: /2 5. The relationship between a firm's capital structure and other company attributes As a firm takes on more debt, its probability of bankruptcy . Other factors held constant, a firm whose earnings are relatively volatile faces a chance of bankruptcy. Therefore, when other factors are held constant, a firm whose earings are relatively volatile should use debt than a more stable firm. When bankruptcy costs become more important, they the tax benefits of debt. Blue Ram Brewing Company currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.15, and its cost of equity is 11.55%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 11.55%. The risk-free rate of interest (Rp) is 3.5%, and the market risk premium (RPM) is 7%. Blue Ram's marginal tax rate is 25%. Blue Ram is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial Information that follows to analyze its weighted average cost of capital (WACC). Complete the following table. D/CapE Ratio /Cap Ratio Bond Rating Cost of Equity Before-Tax Cost of Debt ra) Levered Beta (b) 0.0 1.15 11.55% 1.0 0.8 D/E Ratio 0.00 0.25 0.67 WACC 11.55% 11.530% 13.062% 7.2% 7.7% 8.9% 1.725 15.575% 12.248% 11.99 35.700% Grade It Now Save & Continue Continue without saving

Answer 1

WACC( weighted average cost of capital) is proportion  of debt and equity. It is also called discount  rate which is used for calculating the present value of money.Having less debt as compared to equity is good because company has to pay interest to debt holder which will increase more debt. The dividend is not compulsorily payable to shareholders.

As a firm takes on more debt its probability of bankreeptcy increases. other factors held constant, a firm whose earnings are Irelatively rolatile facer a more chance of bankruptcy. Therefore when other factors are beld conszent, a firm whase earning are relatively volatile should use less debt than a more a stable firm. When bankrupcy costs become more important reducee the tax benefit of debt: * missing amounts can be are calculated by using the weighted average cost of capital (WACC)formular WACC - Proportion of het Equity x cost of Equity __ total value of financing T + proportion of debt cost of debt (1-Tax) Total value of financing (i) Levered beta is calculated below:- E unleveved beta (1+(1-) x (Debt) Equity 1 15*(1 + (1-0.25 x 0.25) 115 *(1+0.75X0.25) = 1.15*(1 +0:1875) = 1.15 x 1.1875 1.1371 Levered beta - 1.37

the D WACC can be calculated bu using following formina WACC - Proportion of Equity xcost of Equity Total value of financing on Proportion of debt xoostet debt (1 - Tax) & Total value of financing 0:6 Xt5.575+0.4770764 025) 1.0 4 .O = 9.345 +231 - 11.655 IWACC= 41.655 6 WASC- Proportion of Equity cost et Equity Tutor financing L o + Beperti pot debtxcost of debt (1-tax) Dites financing 12.248 -0.4x cost of Equity + 0;6x8.964-225) 12.248 - 0.4x cost of Equity + 4.005 12. 248 - 4.005 = 0.4x cost of Equity 100.8. 243 = 0.4x cost of Equin cost of Equuty = 8.243 0.4 foosto £ Equity = 20.608

94) WACC = Bo Destion of Eq ayx cost of Equity Total financing Proportion of debt x cost of debt (1- . Totas financing tax) L. 1.0 = 0.2 x 35.700 +0.8x42025811.9 x 41 -0.25) - 7.14 & 7.14 = 14.280 WACC= 14.280. - en ole Rabios Debt Equity 0.8 0.2 - 4.0 IDLE Ratio = 4.0