Question

< Back to Assignment Attempts: Keep the Highest: 9 7. Capital structure theory Aa Aa E Corporations allowed to deduct interest payments as an expense. Corporations allowed to deduct dividend payments to stockholders as an expense. The differential tax treatment of interest payments and dividend payments encourages firms to use in their capital structure. Debt financing is expensive than common or preferred stock financing. 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 13.78%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 13.78%. The risk-free rate of interest (ra) is 4%, and the market risk premium (RP) is 8.5%. Blue Ram's marginal tax rate is 35% 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. Before-Tax Cost of Debt (ra) Ratio Bond Rating Ratio Levered Beta (b) D/E Ratio 0.00 0.25 Cost of Equity (ro) 13.78% 15.39% 18.03% WACC 13.78% 1.15 0.67 8.1% 8.5% 10.9% 13.94 1.50 1.65 2.27 4.14 13.57 0.8 39.19%

Answer 1

Part 1 solutions for blanks:

1. Corporations are allowed to deduct interest..
2. Corporations are not allowed to deduct dividend...
3. use debt in
4. is less expensive

Part 2:

2.a

To find Levered beta we use the following Hamada equation

b b[1(1- T)(D/E)]

bL =1.15*(1+(1-35%)*(0.2/0.8))

=1.34

2.b

WACC = w(r(1 T) w(r)

= 0.4*8.5%*(1-35%)+0.6*18.03%

= 13.03%

2.c

Cost of equity, rs, can be found by rearranging the above formula for WACC as

rs= (WACC-wd(rd)(1-T))/wc

=(13.57%-0.6*10.9%*(1-35%))/0.4

=23.30%

2.d

D/E Ratio = (D/A)/(E/A)

=0.8/0.2

=4

WACC =

WACC = w(r(1 T) w(r)

=0.8*13.9%*(1-35%)+0.2*39.19%

=15.07%

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