Question

Problem 5

The market value of McDavid Corp. is VL = $200 million. McDavid Corp. has 75,000 6% coupon bonds trading at par. Each bond has a $1,000 face value and the firm’s debt is perpetual. McDavid Corp.’s (levered) equity cost of capital is rE = 10%. Corporate taxes equal 36% and interest expenses are tax deductible, while dividends and other distributions to equity holders are not. Assume that the agency and bankruptcy costs of debt are zero, and that coupons are paid annually. (a) Calculate McDavid Corp.’s weighted average cost of capital (rWACC). (6) (b) What would the value of McDavid Corp. be if it were 100% equity – financed? (7) (c) What would McDavid Corp.’s cost of equity be if it were 100% equity – financed? (7) (d) What would McDavid Corp.’s weighted average cost of capital (rWACC) be if it were 100% equity – financed?

Answer 1

a)	After tax cost of debt = 6%*(1-36%) = 3.84%
	Value of debt = $75 million
	Value of equity = $200m-$75m = $125m
	WACC = 3.84%*75/200+10%*125/200 = 7.69%
b)	Value of levered firm = Value of unlevered firm [VU} +Debt*t
	Substituting available figures into the above equation we have
	$200 m = VU+$75m*36%
	VU (100% Equity) = $200m-$75m*36% = $173 m
c)	Cost of levered equity rE = Cost of unlevered equity [rS] +(Cost of unlevered equity [rS]-Cost of debt)*(1-t)*D/E
	Substituting available figures into the above equation we have
	10 = rS+(rS-6)*0.64*75/125
	Solving for rS
	10*125/(0.64*75)+6 = 2*rS
	rS = ((10*125/(0.64*75))/2 = 13.02%
d)	WACC = 13.02%