Calculate the cost of equity: Assuming that there is an unlevered firm and a levered firm. The basic information is given by the following table. Table 1: Information of the firms Unlevered firm Levered firm EBIT 10,000 10,000 Interest 0 3,200 Taxable income 10,000 6,800 Tax (tax rate: 34%) 3,400 2,312 Net income 6,600 4,488 CFFA 0 -3,200 Assuming that cost of debt =8%; unlevered cost of capital =10%; systematic risk of the asset is 1.5 Fill in the blanks What is the present value of the tax shield? Cost of Capital = (10% x 0.5) + (8% x 0.5 x (1-0.34) = 7.64% PV of Tax Shield = (3,200 x 0.34) / (1+0.0764) = 1,010.78 What is the size of debt? Interest / Cost of Debt (3,200 / 8%) = 40,000 Calculate the following values:a) Value of Unlevered Firm 10,000 x (1-34%) / 10% 6,600 / 10% = 66,000 b) Value of the Levered Firm 66,000 + 34% x 40,000 66,000 + 13,600 = 79,600 c) Equity Value 79,600 = Equity Value + 40,000 Equity Value = 79,600 – 40,000 = 39,600
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.
Calculate the
Assuming that there is an unlevered firm and a levered firm. The basic information is given by the following table.
Table 1: Information of the firms
|
|
Unlevered firm |
Levered firm |
|
EBIT |
10,000 |
10,000 |
|
Interest |
0 |
3,200 |
|
Taxable income |
10,000 |
6,800 |
|
Tax (tax rate: 34%) |
3,400 |
2,312 |
|
Net income |
6,600 |
4,488 |
|
CFFA |
0 |
-3,200 |
Assuming that cost of debt =8%; unlevered cost of capital =10%; systematic risk of the asset is 1.5
- Fill in the blanks
- What is the
present value of the tax shield?
Cost of Capital = (10% x 0.5) + (8% x 0.5 x (1-0.34) = 7.64%
PV of Tax Shield = (3,200 x 0.34) / (1+0.0764) = 1,010.78
- What is the size of debt?
Interest / Cost of Debt
(3,200 / 8%) = 40,000
- Calculate the following values:
a) Value of Unlevered Firm
10,000 x (1-34%) / 10%
6,600 / 10% = 66,000
- b) Value of the Levered Firm
66,000 + 34% x 40,000
66,000 + 13,600 = 79,600
- c) Equity Value
79,600 = Equity Value + 40,000
Equity Value = 79,600 – 40,000 = 39,600
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