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Suppose that a TV manufacturing company is currently financed with 20% debt and 80% equity (at market values). The required return on equity is 15%, and the required return on debt is 5%. For all parts of this question, assume that the Modigliani-Miller theorem holds (i.e., there are no frictions such as taxes, costs of financial distress, asymmetric information, etc.).

Find the WACC given the above information.

Then find the WACC assuming that the capital structure changed to 40% debt and 60% equity and the cost of debt rose from 5% to 6%. What is the company’s weighted-average cost of capital after the debt issuance, given that the cost of debt has risen to 6%? What is the required return on the company’s equity?

Please show all work.

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Jarrod Robel
Jarrod RobelLv2
28 Sep 2019

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Related questions

F2 Q1-5

1.

The return on equity of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm.

a. False.

b. True.

2.

Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on assets to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a. False.

b. Partly true, partly false.

c. True.

3.

Even in a world with no frictions – that is, taxes, costs of bankruptcy, asymmetric information – debt will always be preferred because cost of debt is always lower than cost of equity for a firm.

a. True.

b. False.

c. Partly true, partly false.

4.

In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a. The return on equity is less than the weighted average cost of capital (WACC).

b. The return on equity is greater than the weighted average cost of capital (WACC).

c. The relationship between return on equity and the WACC cannot be determined because it depends on several factors.

5.

In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, the returns on equity of the two firms will:

a. Will depend on the capital structures adopted by the firms.

b. Will depend on the capital structures adopted by the firms and the valuation method used.

c. Always be equal to each other.

d. Will depend on the method of valuation used.

Assume that a firm has no debt in its capital structure. It has expected NOI of sh.100,000 and equity capitalization rate Ke of 10%. Since it is all equity financed, WACC = cost of equity(Ke) i.e 10% Required: Determine the value of the firm Question 2: Assume the firm in question 1 is able to change its capital structure replacing equity by debt of sh.300,000. The cost of debt is 5% Determine i. The value of the firm ii. The WACC Question 3. Suppose the firm uses more debt in place of equity and increases debt to sh.900,000. Cost of debt is 5%. Ke= 10% and NOI is sh.100,000 Determine the value of the firm and the firm’s WACC

The calculation of WACC involves calculating the weighted average of the required rates of return on debt and equity, where the weights equal the percentage of each type of financing in the firm's overall capital structure.

Re is the symbol that represents the cost of raising capital by issuing new stock in the weighted average cost of capital (WACC) equation.

Reymond Co. has $1.1 million of debt, $1 million of preferred stock, and $2.1 million of common equity. What would be its weight on common equity?

a) 0.19

b) 0.24

c) 0.50

d) 0.22

 

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