Question

Luna Corporation has a beta of 1.5, £10 billion in equity, and £5 billion in debt...

Luna Corporation has a beta of 1.5, £10 billion in equity, and £5 billion in debt with an interest rate of 4%. Assume a risk-free rate of 0.5% and a market risk premium of 6%. Calculate the WACC without tax.

Queen Corporation has a debt-to-equity ratio of 1.8. If it had no debt, its cost of equity would be 16%. Its current cost of debt is 10%. What is the cost of equity for the firm if the corporate tax rate is 35%?

Discuss the impact of corporate taxes on the optimal capital structure of the firm in an otherwise perfect capital market.

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Answer #1

Answer to Question 1:

Value of Equity = 10 billion
Value of Debt = 5 billion

Value of Firm = Value of Equity + Value of Debt
Value of Firm = 10 billion + 5 billion
Value of Firm = 15 billion

Weight of Equity = Value of Equity / Value of Firm
Weight of Equity = 10 billion / 15 billion
Weight of Equity = 0.6667

Weight of Debt = Value of Debt / Value of Firm
Weight of Debt = 5 billion / 15 billion
Weight of Debt = 0.3333

Cost of Debt = 4.00%

Risk-free Rate = 0.50%
Beta = 1.50
Market Risk Premium = 6.00%

Cost of Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Equity = 0.50% + 1.50 * 6.00%
Cost of Equity = 9.50%

WACC = Weight of Debt * Cost of Debt + Weight of Equity * Cost of Equity
WACC = 0.3333 * 4.00% + 0.6667 * 9.50%
WACC = 7.67%

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