Corporate Finance - Corporate Finance Section 2

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12. An analyst gathers the following information about the capital structure and before-tax component costs for a company. The company’s marginal tax rate is 35 percent.

CapitalcomponentBook Value(000)Market Value(000)Component cost
Debt  x€ 120€ 1006%
Preferred stock € 60€ 609%
Common stock € 300€ 24013%

  • Option : A
  • Explanation : The company’s weighted average cost WACC is equal to:
    WACC = Wd Rd (1 – t) + Wp Rp + We Re The target capital structure
    is: Market value of equity = 240 / 400 = 60%
    Market value of debt = 100 / 400 = 25%
    Market value of preferred stock = 60 / 400 = 15%>
    Rd (1 – t) = 6% (1 – 35%) = 3.90%, Re = 13%, Rp = 9%
    WACC = 0.25 * 3.9% + 0.15 * 9% + 0.60 * 13% = 10.13%
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13. A.F. Company has a debt to equity ratio of 60% and is subject to taxation at a rate of 40%. Its cost of equity is 17% while its cost of debt is 12.5%. A.F. Company’s weighted average cost of capital is closest to:

  • Option : B
  • Explanation : Wd = (D/E) / (1 + D/E) = 0.6 / (1 + 0.6) = 0.375
    We = 1 - Wd = 1 – 0.375 = 0.625
    WACC = Wd Rd (1 - t) + We Re
    = 0.375 * 0.125 * (1 – 0.4) + 0.625 * 0.17 = 13.44%.
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14. Golden Giants has the following capital structure which is funded from common stock, preferred stock and debt.

Source  AmountCost
Common Stock  100,000,00016.0%
Preferred Stock  2,000,00014.5%
Debt  18,000,00012.0%
Total 120,000,000 

  • Option : B
  • Explanation : WACC = Wd Rd (1 – t) + Wp Rp + We Re = [(18/120) * 0.12 * (1 – 0.35)] + [(2/120) * 0.145] + [(100/120) * 0.16] = 14.745%
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