Question

GlaxoSmithKline plc is a pharmaceutical company. It is considering the replacement of one of its existing machines with a new model. The existing machine can be sold now for £8,000. The new machine costs £50,000 and will generate free cash flows of £11,416.55 p.a. over the next 6 years. The corporate tax rate is 35%. The new machine has average risk. GlaxoSmithKline’s debt-equity ratio is 0.5 and it plans to maintain a constant debt-equity ratio. GlaxoSmithKline’s cost of debt is 5.85% and its cost of equity is 13.10%.

The average debt-to-value ratio in the pharmaceutical industry is 20%. What would GlaxoSmithKline’s cost of equity be if it took on the average amount of debt of its industry at a cost of debt of 5%? Do this calculation assuming the company does not pay taxes.

Answer 1

Debt to Equity = Debt / Equity = 0.5

Weight of Equity = 1 / 1.5 = 0.6667

weight of Debt = 0.5 / 1.5 = 0.333

WACC (Weighted Average Cost of Capital) = (Cost of Equity x weight of Equity) + (Cost of Debt x (weight of Debt (1-tax))

= (13.10% x 0.6667) + (5.85% x (0.3333(1-35%))

= (0.8734) + (0.0585 x 0.21667)

WACC = 10%

Debt / Equity ratio= 20%

Cost of Debt = 5%

WACC = 10%

10% = (cost of equity x 100/120) + (5% x 20/120)

10% = (cost of equity * 0.8333) + 0.8333%

Cost of equity = (10% - 0.8333%) / 0.8333

Cost of equity = 11%