Question

Corporate Financial Management:The Cost of Capital

12. a. Eve Industries has a target capital structure of 41% ordinary equity, 4% preference shares, and 55% debt. Its cost of equity is 19%, the cost of preference shares is 6.5%, and the pre-tax cost of debt is 7.5%. If the firm has a tax rate of 34%, what is the firm’s Weighted Average Cost of Capital (WACC)? (20%)

2. Phillips Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 per cent. The company also has 750,000 shares of 7 per cent preference shares and 2.5 million shares of ordinary equity outstanding. The preference shares sell for €53 a share. The ordinary equity has a beta of 1.34 and sells for €42 a share. The government Treasury bill is yielding 2.8 per cent and the return on the market is 11.2 per cent. The corporate tax rate is 38 per cent. What is the firm's weighted average cost of capital? (60%)

3. When firms choose to issue new debt or equity, what will happen to the WACC? Explain, in detail why this is the case.(20%)

Answer 1

		Eve Industries
a)	Tax Rate	34%
	Before tax cost of Debt	7.5%
	Preferred Stock	4.0%
	Equity Capital	19.0%
	After tax cost of debt=7.5%(1-.34)	0.0495
	Weighted Average Cost of Capital
		(A)	(B)	(A)*(B)
		Capital structure	Cost	WACC
	Equity=	41.00%	19.00%	0.0779
	Debt=	55.00%	4.95%	0.0272
	Preferred Stock	4%	4.0%	0.0016
	WACC	100.00%		0.1067
	WACC=			10.6725	%
		Phillips Equipment
b)
	Risk free rate	2.80%
	Beta	1.34
	expected return on the market	11.2%
	Cost of Equity=Risk free rate+Beta*(Market rate of return-Risk free rate)
	Cost of Equity=2.80%+1.34*(11.2%-2.80%)	0.14056
	Cost of Equity=	14.056%	%
	Return on Preferred stock=(.07*100)/53)	13.208%
	Tax Rate	38%
	Before tax cost of Debt	6.75%
	After tax cost of debt=6.75%(1-.38)	4.19%
	Weighted Average Cost of Capital
	Debt=(80000*1000)=	$                 8,00,00,000.00
	Preferred Stock(750000*$53)	$                 3,97,50,000.00
	Equity(2500000*$42)	$               10,50,00,000.00
	Total	$               22,47,50,000.00
	Debt %=($80000000/$224750000)	35.60%
	Preferred Stock %(39750000/$224750000)	17.69%
	Equity %=($105000000/$224750000)	46.72%
		(A)	(B)	(A)*(B)
		Capital structure	Cost	WACC
	Equity=	46.72%	14.06%	0.0657
	Debt=	35.60%	4.19%	0.0149
	Preferred Stock	17.69%	13.21%	0.0234
	WACC	100.00%		0.1039
	Weighted Average cost of capital	10.39	%
c )	Weighted average cost of capital is the combination of debt and equity cost.
	When the company's debt equity ratio increases, its weighted average cost of capital decreases.