Question

Dell's balance sheet

	Assets	Liabilities
Fixed Investments	£18,000
Debt		?
Equity		?

The beta of Dell’s fixed investments is 1.5. The risk-free rate is 3% and the average return on the market index is 7%. The debt-equity ratio is 0.5.

1. What are the values of Dell’s debt and equity?

2. What is Dell's weighted average cost of capital?

3. Dell’s cost of borrowing is 3.5%. What is Dell’s the cost of equity capital?

4. what would the cost of Dell’s equity be if the debt-equity ratio increases to 1.0? Assume that the increase in borrowing increases the cost of borrowing to 3.6%. (Modigliani-Miller irrelevance of borrowing policy holds)

5. Modigliani-Miller irrelevance of borrowing does not hold, so the increase in borrowing will increase both the PV of the corporate tax shield of borrowing and the PV of the expected bankruptcy costs. The PV of the tax shield is £0.6bn and the PV of the bankruptcy costs is £0.1bn. The cost of debt capital is 3.6% and the debt-equity ratio increases to 1.0. Assuming that both the PV of the tax shield and the PV of the bankruptcy costs have a beta of 1.5, what are the new WACC and the new cost of equity capital?                

Answer 1

Answer to 1 to 3 Questions
Fixed Investments	£                   18,000.00
Debt-equity ratio	0.5
Value of debt	= 18,000 * 0.5/1.5
	= 6,000/- GBR
Value of equity	= 18,000 * 1/1.5
	= 12,000/- GBR
Cost of Borrowings	3.50%
Cost of Equity	= 3% + (7% - 3%) 1.5
	= 9%
WACC	= 3.5% * 1/3 + 9% * 2/3
	= 7.166%

Answer to question no. 4:

If Debt-equity ratio	1
Cost of Borrowings	3.60%
Beta unlevered	= Bl/(1+D/E)
	= 1.5 / (1+0.5/1.5)
	= 1.125
Beta levered when D/E =1	=1.125*(1+0.5)
	= 1.6875
Cost of Equity	= 3% + (7% - 3%) 1.6875
	= 9.75%

Answer of question no 4 is answer of question no 5 as MM theory holds irrelevance.