Professional Documents
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Assessment:
First we have tried to calculate Cost of Capital at three different Debt to Capital
Ratios: (1) 0%, (2) 20%, (3) 40%, (4) 60%.
Following data is made use of:
(1) Yield to maturity on 10 year maturities: 1.8%
(2) At 20% Debt to Capital ratio the assumed bond rating is AAA/AA and the
interest rate is 2.85%, at 40% Debt to Capital ratio the assumed bond
rating is BBB and the interest rate is 4.4%, and at 60% Debt to Capital
ratio the assumed bond rating is B and the interest rate is 7.7%. The debt
issued has a maturity of 10 years.
(3) The corporate income tax rate is 35.5%
(a) 0% Debt to Capital
Cost of Debt is zero
Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta
B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta)
Since in the present case, Debt is zero,
B=B1
Since B1 is not given, we assume it to be 1 for the current situation and other
following situations.
Thus, cost of equity is 3.8% (10 year maturity Bond Yield of bonds issued by A
rated companies. Here we assume M/s Hill Country Snacks Foods Co. to be A
rated, in absence of any particular assigned rating to the company.)
WACC= 3.8%
(b) 20% Debt to capital
B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta)
B=B1[1+(1-0.355)(145/580)]
B=1.16
(B1 is assumed 1, Debt is $145mn, Equity is $580mn, Corporate tax rate (t) is
35.5%)
Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta
Cost of Equity= 1.80+1.16(2.85-1.8)
Cost of Equity= 3.018
Cost of Debt= 2.85%
WACC= Cost of Equity [Equity/(Debt+ Equity)] + Cost of Debt (1-t) [Debt/
(Debt+Equity)]
WACC= 3.018[0.80]+2.85(1-0.355)[0.2]
WACC= 2.78
(c) 40% Debt to Capital
B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta)
B=B1[1+(1-0.355)(290/435.1)]
B=1.43
(B1 is assumed 1, Debt is $290mn, Equity is $435.1mn, Corporate tax rate (t) is
35.5%)
Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta
Cost of Equity= 1.80+1.43(4.4-1.8)
Cost of Equity= 5.518
Cost of Debt= 4.4%
WACC= Cost of Equity [Equity/(Debt+ Equity)] + Cost of Debt (1-t) [Debt/
(Debt+Equity)]
WACC= 5.518[0.60]+4.4(1-0.355)[0.4]
WACC= 4.446
(d) 60% Debt to Capital
B=B1[1+(1-t)(Debt/Equity)]; (where, B1= Unlevered Beta)
B=B1[1+(1-0.355)(435/290)]
B=1.48
(B1 is assumed 1, Debt is $435mn, Equity is $290.1mn, Corporate tax rate (t) is
35.5%)
Cost of Equity: Risk free rate + B(Risk Premium); where, B=Levered Beta
Cost of Equity= 1.80+1.48(7.7-1.8)
Cost of Equity= 10.532
Cost of Debt=7.7%
WACC= Cost of Equity [Equity/(Debt+ Equity)] + Cost of Debt (1-t) [Debt/
(Debt+Equity)]
WACC= 10.532[0.40]+7.7(1-0.355)[0.6]
WACC= 7.1927
Conclusion: Thus, we have seen from above, that Cost of Capital is minimum at
20% Debt to Capital. Further, introduction of 20% Debt in the capital structure
would provide following benefits:
(i)
The firm would be able to improve the profitability position and thus
shareholder value due to reduced tax outgo on the interest expenses.
(ii)