Firm A’s capital structure contains 20 percent debt and 80 percent equity. Firm B’s capital structure contains 50 percent debt and 50 percent equity. Both firms pay 7 percent annual interest on their debt. The stock of Firm A has a beta of 1.0, and the stock of Firm B has a beta of 1.375. The risk-free rate of interest equals 4 percent, and the expected return on the market portfolio equals 12 percent.

a. Calculate the WACC for each firm, assuming there are no taxes.

b. Recalculate the WACC figures, assuming that the firms face a marginal tax rate of 34 percent.

c. Explain how taking taxes into account in part (b)Defination WACC WACC = E × re + D × (1 - t) × rd + P × rp (E+D+P) (E+D+P) (E+D+P) Where: E = Market value of equity D = Market value of debt P = Market value of preferred stock re = Cost of equity rd = Cost of debt rp = Cost of preferred stock t = Marginal tax rate Defination Cost of Equity The cost of equity is usually calculated using the capital asset pricing model (CAPM), which defines the cost of equity as follows: re = rf + ß × (rm - rf) Where: rf = Risk-free rate (represented by 10-yr U.S. Treasury bond rate) ß = Predicted equity beta (levered) (rm - rf) = Market risk premium Answer a Firm A Since Prefered stock is 0, and percentage of Equity is given as 80% , and percentage of debt is 20%. Cost of debt is given as 7%. We have to calculate the cost of equity. With the above formulae, cost of equity will be:- re=4+(12-4)X1=4+8=12% Substituting all the values in the above WACC formulae taking tax as 0%:- WACC=( 0.8*12)+(0.2*7)= 9.6+1.4=11% Firm B Since Prefered stock is 0, and percentage of Equity is given as 50% , and percentage of debt is 50%. Cost of debt is given as 7%. We have to calculate the cost of equity. With the above formulae, cost of equity will be:- re=4+(12-4)X1.375=4+11=15% Substituting all the values in the above WACC formulae taking tax as 0%:- WACC=( 0.5*15)+(0.5*7)= 7.5+3.5=11% Answer b

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Status NEW Posted 04 Aug 2017 12:08 PM My Price 8.00

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