Question 16.4: This is a comprehensive example that illustrates most of the...
This is a comprehensive example that illustrates most of the points we have discussed thus far. You are given the following information for the Format Co.:
EBIT = $126.58
T_{C} = .21
D = $500
R_{U} = .20
The cost of debt capital is 10 percent. What is the value of Format’s equity? What is the cost of equity capital for Format? What is the WACC?
This one’s easier than it looks. Remember that all the cash flows are perpetuities. The value of the firm if it has no debt, V_{U}, is:
V_{U}=\frac{EBIT − Taxes}{R_{U}}=\frac{EBIT \times (1-T_{C})}{R_{U}}
=\frac{\$100}{.20}
= $500
From M&M Proposition I with taxes, we know that the value of the firm with debt is:
V_{L} = V_{U} + T_{C} × D
= $500 + .21 × $500
= $605
Because the firm is worth $605 total and the debt is worth $500, the equity is worth $105:
E = V_{L} − D
= $605 − 500
= $105
Based on M&M Proposition II with taxes, the cost of equity is:
R_{E} = R_{U} + (R_{U} − R_{D}) × (D/E) × (1 − T_{C})
= .20 + (.20 − .10) × ($500/$105) × (1 − .21)
= .5762, or 57.62%
Finally, the WACC is:
WACC = ($105/$605) × .5762 + ($500/$605) × .10 × (1 − .21)
= .1653, or 16.53%
Notice that this is lower than the cost of capital for the firm with no debt (R_{U} = 20 \% ), so debt financing is advantageous