6. (a) The following information is given for 3 companies that are identical exc

Question

6. (a) The following information is given for 3 companies that are identical except for their capital structure Orange 100,000 0.8 6,100 16% 26% 25,000 8,970 Grape Total invested capital Debt/assets ratio Shares outstanding Pre tax cost of debt Cost of equity Operating Income (EBIT) Net Income Apple ,00,00000,000 0.2 10,000 15% 20% 25,000 4,950 0.5 8,300 13% 2 25,000 12,350 The tax rate is uniform 35% in all cases (i) Calculate the Weighted average cost of capital for each company (ii) Calculate the Economic Valued Added (EVA) for each company (ii) Recommend on the basis of EVA, which company would be considered for best investment by giving reasons

Explanation / Answer

Orange Grape Apple Total Invested capital 100000 100000 100000 Debt/assets ratio 0.8 0.5 0.2 Shares O.s 6100 8300 10000 Pre tax cost of debt 16% 13% 15% Cost of Equity 26% 22% 20% EBIT 25000 25000 25000 Net Income 8970 12350 14950 After Tax cost of debt 16%(1-0.35) 13%(1-0.35) 15%(1-0.35) 10.40% 8.45% 9.75% Cost of Equity 26% 22% 20% Weight of debt 80 50 20 Weight of Equity 20 50 80 WACC (0.80*0.104)+(0.20*0.26) (0.50*0.0845)+(0.50*0.22) (0.20*0.0975)+(0.80*0.20) 13.52% 15.23% 17.95% EVA = Net Income - Invested capital*WACC 8970-(100000*13.52%) 12350-(100000*15.23%) 14950-(100000*17.95%) EVA -4550 -2880 -3000

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