Question

2) (18 Marks)Torcara Inc. is currently an all-equity firm with a market value of $4,000,000. Additionally, the firm plans to pay all its future earnings as cash dividends to its shareholders. Assume the following: T-Bill rate = 3% Expected return on the market = 10% Torcara's unlevered beta = 1 Part 1: Consider a world with no taxes and no bankruptcy costs: a) According to CAPM, what is the cost of equity for Torcara? (2 marks) b) What is the WACC for Torcara? (1 mark) c) What is the optimal capital structure for Torcara? Briefly explain. (1 mark) Part 2: Consider a world with taxes but no bankruptcy costs. The tax rate is 35%. The market value of the all equity firm is $4,000,000. d) What is the optimal capital structure of Torcara? No calculation required. Briefly explain. (1 mark) e) What would be the value of Torcara if it plans to add $2,750,000 of debt with a coupon rate of 7% to its capital structure? Debt will be sold at par value and will be used to repurchase shares. (2 marks) f) What would be the cost of equity of Torcara if it plans to add $2,750,000 of debt with a coupon rate of 7% to its capital structure? Debt will be sold at par value and will be used to repurchase shares. (3 marks) g) What would be the WACC of Torcara if it plans to add $2,750,000 of debt with a coupon rate of 7% to its capital structure? Debt will be sold at par value. (3 marks)

Answer 1

Answering Part 1

a. As per CAPM

Cost of equity = Risk free rate + Beta*(Expected Market return - Risk free rate)

Risk free rate = T Bill rate = 3%

Expected Market return =10%

Beta = 1

Cost of Equity - 3% + 1 * (10-3)%

= 3% +7%

=10%

b. Since ita an all equity firm WACC = Cost of Equity = 10%

c. Optimal capital structure would be to have a mix of Debt and Equity there by bringing the WACC. In general 60% Equity and 40% DEbt is considered optimal.