Industrialization Automation Co. currently has no debt in its capital structure,
ID: 2763717 • 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 1.15, and its cost of equity is 12.78%. Because the firm has no debt in its capital structure, its weighted average cost of capital also equals 12.78%. The risk free rate of interest is 3% and the market risk premium is 8.5%. Industrialization Automation Co's marginal tax rate is 30%. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table.
D/A ratio E/A ratio d/e ratio Bond rating before tax cost o debt levered beta Cost of equity WACC 0 1 0 - - 1.15 12.78% 12.78% 0.2 0.8 0.25 A 7.20% 14.48% 12.59 0.4 0.6 0.67 BBB 7.70% 1.69 17.37% 0.6 0.4 1.5 BB 8.90% 2.36 12.96 0.8 0.2 C 11.90% 4.37 40.15%Explanation / Answer
Given : Risk Free rate=Rf= 3.0% Market Risk premium=Mrp= 8.5% Unlevered beta= 1 Tax rate 30% Cost of levered Equity =Rf+Rpm*Lecered Beta WACC = D/(D+E)*Kd +E/(D+E)*Ke Kd =post tax cost of debt, ke=levered equity cost, D=Debt value, E=Equity Value D/A ratio=D/(D+E) E/A ratio =E/(E+A) d/e ratio Bond rating before tax cost o debt After Tax cost of Debt=0.70*Pretax cost levered beta Cost of equity WACC 0 1 0 - - 1.15 12.78% 12.78% 0.2 0.8 0.25 A 7.20% 5.04% 1.35 14.48% 12.59 0.4 0.6 0.67 BBB 7.70% 5.39% 1.69 17.37% 12.58% 0.6 0.4 1.5 BB 8.90% 6.23% 2.36 23.06% 12.96 0.8 0.2 4 C 11.90% 8.33% 4.37 40.15% 14.69%