Industrialization automation co. currently has no debt in its capital structure,
ID: 2742577 • Letter: I
Question
Industrialization automation co. currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity. The firm's unlevered beta is 1.2, and its cost of equity is 12.60%. Because the frim has no debt in its capital structure, its weighted average cost of capital also equals 12.60%. The risk free rate of interest is 3%, and the market risk premium is 8%. Industrialization automation co's marginal tax rate is 35%. Industrialization automation co is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost capital. Please help me complete a-e in the preceeding table, thanks.
D/A RATIO E/A RATIO D/E RATIO BOND RATING before tax cost of debt levered beta cost of equity wacc 0.0 1.0 0.00 ----- ---- 1.2 12.60% 12.60% 0.2 0.8 0.25 A 8.1% (a?) 14.20% 12.41% 0.4 0.6 0.67 BBB 8.5% 1.72 16.76% (b?) 0.6 0.4 1.50 BB 10.9% 2.37 (c?) 13.04% 0.8 0.2 (d?) C 13.9% 4.32 37.56% (e?)Explanation / Answer
1. The cost of Equity under CAPM is : - Cost of Equity = Risk free rate + Beta (Risk Premium).
2. Always after tax Cost of Debt is used to calculate WACC.
3. WACC = D/A * After tax cost of Debt + E/A * Cost of Equity.
a. Let, Levered Beta = x
Ke = Risk free rate + Beta (Risk Premium).
14.2 = 3 + x(8),
x = (14.2-3)/8 = 1.4.
b. WACC = D/A * After tax cost of Debt + E/A * Cost of Equity. = 0.4 * [8.5(.65)] + 0.6 * 16.76
= 0.4 * 5.525 + 0.6 * 16.76 = 2.21 + 10.05 = 12.26 %
c. Cost of Equity = Risk free rate + Beta (Risk Premium).
= 3 + 2.37 (8) = 3 + 18.96 = 21.96 %.
d. D/E Ratio = D/A Ratio divided by E/A Ratio = 0.8 / 0.2 = 4
e. WACC = [D/A * After tax cost of Debt] + [E/A * Cost of Equity]. = {0.8 * [13.90 (0.65)]} + {0.2 * 37.56}
= 0.8 * 9.035 + 7.512 = 7.228 +7.512 = 14.74%.