Question

You expect your firm to be worth $50, $100, or $120 with probabilities 1/10, 6/10 and 3/10, respectively. You can raise $75 in debt proceeds today if you promise an interest rate of 10%. If this is how you finance your firm, then your cost of equity capital is 20%

. What is the value of your firm

What is your firm’s WACC?

If you raise $50 in debt proceeds today, your friendly investment banker tells you that you can get away promising an interest rate of 3%. What is your debt cost of capital in this case?

How much would then be financed through equity (in the $50-debt financing scenario)?

Answer 1

The firm is expected to have a value of $ 50, $ 100 and $ 120 with probabilities of 0.1, 0.6 and 0.3 respectively.

Expected Firm Value = 50 x 0.1 + 100 x 0.6 + 120 x 0.3 = $ 101

Debt Raised = $ 75 and Interest Rate = 10 %

The interest paid in lieu of raising debt is the cost that the company incurs for possessing debt in its capital structure. Hence, the company's cost of debt is equal to the interest rate paid on its debt.

Cost of Debt = 10% and Cost of Equity Capital = 20 %

Therefore, Company WACC = 10 x (75/101) + 20 x (101-75/101) = 12.57 % approximately (tax is not mentioned and hence has been assumed to be zero).

If Debt = $ 50, then equity required = Expected Firm Value - Debt Raised = 101 - 50 = $ 61

Cost of Debt = Interest Promised = 3 %