Purple Inc. has 10 million shares outstanding, now trading at £75 per share. It has also issued £200 million long-term bonds at an interest rate of 8 percent. The firm estimated the expected rate of return for shareholders to be 20 percent in the levered company. a) If there is no corporate tax applicable to this company, what is Purple Inc.’s WACC? b) Now assume Purple Inc. pays tax at a marginal rate of 35 percent. What is the company’s after-tax WACC? c) How much higher would the WACC be if the company used no debt at all? (For this problem you can assume that the firm’s overall asset return is not affected by its capital structure or by interest tax shields).
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.
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