Your colleague collects the information in Table 1. Included are D/E ratios and estimated equity betas for firms similar to the take-over tarket, the target firm's Debt-to-Firm Value ratio, the target firm's tax rate, and the average YTM and coupon payments for their outstanding debt. Using this data, find the appropriate WACC for this investment decision. Hint: Firm Value is Debt + Equity. Therefore, D/(D+E) = 0.2. Use this to solve for D/E, the target firm's leverage ratio. D/E Equity Beta Target D/V 20% Competitor 1 29.90% 2.68 Tax Rate 40% Competitor 2 -7.60% 1.94 Average YTM 6% Competitor 3 32.20% 1.92 Average Coupon 6.50% Competitor 4 49.70% 1.12 Equity Market Risk Premium 5% Competitor 5 21.70% 0.97 Treasury Note 4.93% Competitor 6 34.30% 2.13 WACC Competitor 7 28.50% 1.27 Competitor 8 -6.70% 1.01 Competitor 9 42.60% 0.98
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.
Your colleague collects the information in Table 1. Included are D/E ratios and estimated equity betas for firms similar to the take-over tarket, the target firm's Debt-to-Firm Value ratio, the target firm's tax rate, and the average YTM and coupon payments for their outstanding debt. Using this data, find the appropriate WACC for this investment decision.
Hint: Firm Value is Debt + Equity. Therefore, D/(D+E) = 0.2. Use this to solve for D/E, the target firm's leverage ratio.
| D/E | Equity Beta | Target D/V | 20% | ||
| Competitor 1 | 29.90% | 2.68 | Tax Rate | 40% | |
| Competitor 2 | -7.60% | 1.94 | Average YTM | 6% | |
| Competitor 3 | 32.20% | 1.92 | Average Coupon | 6.50% | |
| Competitor 4 | 49.70% | 1.12 | Equity Market Risk Premium | 5% | |
| Competitor 5 | 21.70% | 0.97 | Treasury Note | 4.93% | |
| Competitor 6 | 34.30% | 2.13 | WACC | ||
| Competitor 7 | 28.50% | 1.27 | |||
| Competitor 8 | -6.70% | 1.01 | |||
| Competitor 9 | 42.60% | 0.98 | |||
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