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Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between...

Q Corporation and R Inc. are two companies with very similar characteristics. The only difference between the two companies is that Q Corp. is an unlevered firm, and R Inc. is a levered firm with debt of $5 million and cost of debt of 10%. Both companies have earnings before interest and taxes (EBIT) of $2 million and a marginal corporate tax rate of 40%. Q Corp. has a cost of capital of 15%.

e. What is R’s cost of equity capital?

f. What is Q’s WACC?   

g. What is R’s WACC?

h. Compare the WACC of the two companies. What do you conclude?

i. What principle have you proven in this case?   

j. Both companies are now evaluating a project that requires an initial investment of $1.15 million and that will yield cash inflows of $500,000 per year for the next three years. Assume that this project has the same risk level as the individual firm’s assets. Should Q invest in this project? Should R invest in this project?

k. Based on your results for part (j), discuss the effects of leverage and its tax shields effects on the future value of the two firms.

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Answer #1

EBIT Interest EBT Tax @ 40% EAT Cost of capital Value of firm 2 0.5 1.5 0.6 0.9 0.8 15% 8.00 Since two companies are with very similar characteristics their cost of equity shall be same The cost of capital is of firm Q is given i.e. 15% which is equal to cost of equity as there is no debt So the cost of equity for R is 15%. 10 12 13 14 15 16 17 18 19 20 21 Q WACC will be equal to 15% as there is no debt g) Weight Funds Cost Equity Debt 15% 45% 8.00 75% WACC 9.38% 23 24 25 The WACC of the company R is lower than Q because it is taking advantage of the debt. The cost of debt is less than the return on equity So the WACC of R is lowEBIT Interest EBT Tax @ 40% EAT Cost of capital Value of firm 2 2 :5*10% -D2-D3 :04*40% -D4-D5 4 -C2-C3 -c4*40% -C4-C5 0.15 10 Since two companie The cost of capital is So the cost of equity 12 13 Q WACC will be equ g) Weight Funds Equity Debt 16 | -D17 E17 -D18 E18 0.15 -10% (1-40%) SUM(E17:E18) SUM(F17:F18) 19 20 21 WACC -F19/E19 23 24 25 The WACC of the cor So the WACC of R is l sni

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