Question

"Increasing financial leverage increases both the cost of debt (rdebt) and the cost of equity (requity). So the overall cost of capital cannot stay constant." This problem is designed to show that the speaker is confused. Buggins Inc. is financed equally by debt and equity, each with a market value of $1 million. The cost of debt is 5%, and the cost of equity is 10%. The company now makes a further $250,000 issue of debt and uses the proceeds to repurchase equity. This causes the cost of debt to rise to 6% and the cost of equity to rise to 12%. Assume the firm pays no taxes. a. After the debt issue, what percent of the firm is financed with debt? (Do not round intermediate calculations. Enter your answer as a whole percent.) Percentage of debt C % b. After the debt issue, what percent of the firm is financed with equity? (Do not round intermediate calculations. Enter your answer as a whole percent.) Percentage of equity % c. What is the overall cost of capital? (Enter your answer as a percent rounded to 1 decimal place.) Cost of capital

Answer 1

Each market value is $1,000,000

So existing Equity = $1,000,000

Existing debt = $1,000,000

Debt issued = $250,000

Repurchased equity = 250000

So new debt = Existing + new issued

=1000000+250000

=1250000

New equity = Existing equity - Shares repurchased

=1000000-250000

=750000

Answer a.

Percentage of debt = Debt /(Debt + equity)

=1250000/(1250000+750000)

=0.625 or 62.50%

Percentage of debt is 62.50%

Answer b.

Percentage of equity =equity/(Debt + equity)

=750000/(1250000+750000)

=0.375 or 37.50%

percentage of equity is 37.50%

Answer c.

Weighted average cost of capital = (weight of debt*cost of debt)+(weight of equity * cost of equity)

=(62.50%*6%)+(37.50%*12%)

=0.0825 or 8.25%

So overall cost of capital is 8.25%

(please thumbs up or post comments if any query)