Question 1 Firm A’s capital structure contains 20% debt and 80% equity. Firm B’s capital structure contains 50% debt and 50% equity. Both firms pay 7% annual interest on their debt. Firm A’s shares have a beta of 1.0 and Firm B’s beta of 1.375. The risk-free rate of interest equals 4%, and the expected return on the market portfolio equals 12%. Required A. Calculate the WACC for each firm assuming there are no taxes. B. Recalculate the WACC figures assuming that the two firms face a marginal tax rate of 34%. What do you conclude about the impact of taxes from your WACC calculations? C. Explain the simplifying assumptions managers make when using WACC as a project discounting method and discuss some of the common pitfalls when using WACC in capital budgeting.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Question 1
Firm A’s capital structure contains 20% debt and 80% equity. Firm B’s capital structure
contains 50% debt and 50% equity.
Both firms pay 7% annual interest on their debt. Firm A’s shares have a beta of 1.0
and Firm B’s beta of 1.375. The risk-free rate of interest equals 4%, and the expected
return on the market portfolio equals 12%.
Required
A. Calculate the WACC for each firm assuming there are no taxes.
B. Recalculate the WACC figures assuming that the two firms face a marginal
tax rate of 34%. What do you conclude about the impact of taxes from your
WACC calculations?
C. Explain the simplifying assumptions managers make when using WACC as
a project discounting method and discuss some of the common pitfalls
when using WACC in capital budgeting.
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