Assuming that ABC Firm has an optimal capital structure; comprised of debt, pref
ID: 2671696 • Letter: A
Question
Assuming that ABC Firm has an optimal capital structure; comprised of debt, preferred stock and common equity. In this scenario, Firm currently has 45 percent debt, 2 percent preferred stock and 53 percent common equity in its capital structure. Firm’s before-tax cost of debt is 10 percent and corporate tax rate is 40 percent; beta for common stock is 0.85 with market return 14% and T-bills return 10%; whereas cost of preferred stock is 10.3 percent.Required:
1. Keeping in view the above mentioned information what would be the values of the firm’s:
? After tax cost of debt ‘Kd(1 - T)’
? Weighted average cost of capital ‘WACC’
Note: Detailed working is not required.
2. You need to stimulate your thought and discuss the impact (increase/ decrease) on firm’s cost of equity ‘Ks’ and weighted average cost of capital ‘WACC’ if volatility of ABC Firm’s stock is increased up to 1.8. Give logical justification of your answer.
Note: Your discussion should not exceed 50 words.
Explanation / Answer
? After tax cost of debt ‘Kd(1 - T)’ = 10(1-0.4) = 6% answer ? Weighted average cost of capital ‘WACC’ 6*45% + 2*10.3% + 53*13.4% = 10.008% answer If the volatility of ABC Firm’s stock is increased up to 1.8, then the firm’s cost of equity ‘Ks’ and weighted average cost of capital ‘WACC’ will alse increase, as the cost of equity has beta in its formula whihc is nothing but volatility, high beta means high cost of equity. Further WACC depends on cost of equity so high cost of equity would mean high WACC.. HHappy to help