Cost of capital Income statement for XYX Inc. for the most recent financial year
ID: 2795166 • Letter: C
Question
Cost of capital
Income statement for XYX Inc. for the most recent financial year is presented below (in million EUR): EBIT 130 Interest expense 30 Earnings before taxes (EBT) 100 Taxes 25 Net income 75 The company has 10 million shares outstanding. The shares are currently trading at the level of P/E (price earnings ratio) = 12 times. The company has released the following forecasts: 80% of net income will be paid out as dividends in the future. Expected (long-term) growth rate of both net income and dividends is 3% annually. The company also uses bank financing quite extensively. The level of debt has been quite stable recently and has remained at the level of 600 million EUR for quite some time. The company is going to issue new debt if necessary in order to maintain the current level of leverage.
Questions:
a) Find the cost of equity and debt
b) Find the market value weights for both sources of capital
c) Calculate the after-tax cost of capital (WACC) and explain briefly what does this result mean?
Explanation / Answer
XYZ Inc. Mlns. EBIT 130 Less: Interest expense 30 EBT 100 Less:Taxes 25 Net Income 75 No.of shares o/s(Mlns.) 10 EPS= 75/10= $ 7.5 P/E= MPS/EPS= 12 So, Market Price,MPS= 7.5*12= $ 90 Dividends=80%*7.5= 6 E&D growth rate= 3% a. Cost of equity,Ke=(D1/P0)+3% Ke=((6*1.03)/90)+3% 9.87% Cost of equity,Ke= 9.87% Cost of Debt=Interest expense/Debt amount= ie. 30/600= 0.05 5% After-tax cost of debt= Before-tax cost*(1-Tax Rate) ie. 5%*(1-25%)= 3.75% b. Market values of weights MV of Equity=10 mln.*$ 90/share= 900 MV of Debt (given) 600 Total MV value of XYZ 1500 Wt. of Equity=900/1500= 60% Wt. of Debt=600/1500= 40% WACC (60%*9.87%)+(40%*3.75%)= 7.42% c. WACC is the most nearest estimation of a company's cost of its sources of finances, when all such sources are weighted & aggregated.This is the minimum required rate of return, a company should expect to earn, in all its investments/projects.