Question

M&M Enterprises is a publicly traded company. It currently has 50 million shares trading at $20/share and $250 million in book value of equity. The firm also has book value of debt of $ 75 million and market value of debt of $ 100 million. The firm also has operating lease commitments, 30 million in each of the next 10 years. The cost of equity for the company is 12%, the pre-tax cost of debt is 4% and the marginal tax rate is 40%. What is the cost of capital?

a.

12.14%

b.

7.55%

c.

9.55%

d.

8.23%

e.

10.65%

Answer 1

Debt value of leases = PV of annuity of $30 million @4% for 10 years

= $30 million * [{1 - (1 + 0.04)^-10} / 0.04]

= $30 million * [0.3244 / 0.04]

= $30 million * 8.1109

= $243.33

Total Market Value of Debt = 100 + 243.33 = $343.33 million

Market Value of Equity = Share Price * Shares Outstanding

= $20 * 50 million = $1000 million

Total Market Value of firm = Market Value of Debt + Market Value of Equity

= 343.33 + 1000 = $1343.33 million

WACC = [wD * Pre-tax kD * (1 - t)] + [wE * kE]

= [(343.33/1343.33) * 4% * (1 - 0.40)] + [(1000/1343.33) * 12%]

= 0.61% + 8.93% = 9.55%

So, Option "c" is correct.