Question

Company A (100% equity) is valued at $15,000,000 and company B ( which has $3,000,000 in long term debt with an interest rate of 8%). Tax rate is 30%. Both A and B have identical after-tax profit $1,200,000 and it is given that both have identical operating risk profile and identical pretax income. Calculate;
a) Value of B
b) Capital structure mix of B
c) Cost of capital for A and B

Answer 1

a)	Value of B (Levered Company) = Value of A (Unlevered Company) + Debt of B*Tax rate = 15000000+3000000*8% =	$         1,52,40,000
b)	Capital structure mix of A & B:
	Value of debt	$             30,00,000
	Value of equity (15240000-3000000) =	$         1,22,40,000
	Proportion of debt = 3000000/15240000 =	19.69%
	Proportion of equity = 12240000/15240000 =	80.31%
	Proportion of debt and equity is 19.69%:80.31%

c)	Cost of capital for A = 1200000/15000000 =	8.00%
	Cost of capital for B:
	Cost of debt = 0.08*(1-0.30) =	5.60%
	Cost of equity = (1200000-3000000*8%*70%)/12240000 =	8.43%
	WACC = 5.60*19.69%+8.43*80.31% =	7.87%