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?

Question

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[latex]_{C}[/latex] = .21
D = $500
R[latex]_{U}[/latex] = .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?

Accepted Answer

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[latex]_{U}[/latex], is:

[latex]V_{U}=\frac{EBIT − Taxes}{R_{U}}=\frac{EBIT imes (1-T_{C})}{R_{U}} [/latex]

[latex]=\frac{\$100}{.20} [/latex]

= $500

From M&M Proposition I with taxes, we know that the value of the firm with debt is:

[latex]V_{L} = V_{U} + T_{C} × D[/latex]
= $500 + .21 × $500
= $605

Because the firm is worth $605 total and the debt is worth $500, the equity is worth $105:

E = V[latex]_{L}[/latex] − D
= $605 − 500
= $105

Based on M&M Proposition II with taxes, the cost of equity is:
[latex]R_{E} = R_{U} + (R_{U} − R_{D}) × (D/E) × (1 − T_{C})[/latex]
= .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 ([latex]R_{U} = 20 \% [/latex]), so debt financing is advantageous

Question 16.4: This is a comprehensive example that illustrates most of the...

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