Question

Suppose a firm financed a $150 million perpetual debt and with 10 million shares each worth $1. The expected return on the debt is 8% and the expected return on equity is 16%. The tax rate is 40%. What is the company's cost of capital financed with debt and what is the value of the firm if it were solely financed by equity?

Answer 1

cost of capital financed with debt rd

rd = RD*( 1 - t)

RD = The expected return on the debt = 8%

t = tax rate = 40% = 0.4

cost of capital financed with debt rd

rd = 8% * ( 1 -0.4) = 4.8%

cost of equity re = 16%

Now

Weight of Debt wd = Debt / (Debt + Equity)

Debt = Value of perpetual debt = $150 million

Equity = No of Shares out Standing * Worth of Each Share = 10 million * $ 1 = $ 10 million

Weight of Debt Wd = Debt / (Debt + Equity) = 150 / ( 150 + 10) = 15 / 16 = 0.9375

Weight of Equity We= Equity / (Debt + Equity) = 10 / ( 150 + 10) = 1 / 16 = 0.0625

Weighted Average cost of Capital

= wd * rd + we * re  

=0.9375 * 4.8% + 0.0625 * 16%  

=4.5% + 1% = 5.5%

Ans :

cost of capital financed with only debt (rd)	4.8%
cost of capital financed with only Equity (re)	16%
cost of capital financed with both Debt and Equity	5.5%