Question

Prob 16: a : Firm's market value capital structure = security quantity * market value of the security = 6.3m*74+0.35m*107+0.15m*1090=$667.15m b: The firm should use the WACC to discount the projects' cash flows. The WACC of the firm = We*Ce + Wp*Cp+Wd*Cd*(1-t) Ce = Req return = rf + B * mp = 0.043+1.09*0.068=0.11712 The WACC of the firm = (466.2/667.15)*0.11712 + (37.45/667.15)*0.058 +(163.50/667.15)*0.071*(1-0.34) = 0.096583 or 9.66%

Question 3 - In your own words explain how taking on more debt could reduce Organic Produce Corporation’s cost of capital, potentially leading to the optimal capital structure, but also leading to increased risk to the business?

Answer 1

Taking more debt can reduce the cost of capital of the company primarily because of the tax advantage on interest expenses. Equity does not receive tax advantage because dividend is considered to be an appropriation of profit and not an expense. Debt however has a lower cost because interest is tax deductible.

The disadvantage of taking more debt is that it increases the risk of the business. Firstly the interest payments are a burden on the company because they are usually fixed and have to be paid irrespective of whether the company has had profits or a loss. Also unlike equity capital debt has to be repaid at maturity. This creates another burden on the business and increases its risk.