Company X has a total market value of €10 million. The market value of equity is

Question

Company X has a total market value of €10 million. The market value of equity is €6 million and the company carries debt valued at €4 million. The before-tax cost of debt is 8%. The cost of equity is estimated at 13%. The marginal tax rate is 35%.

a) Estimate the weighted-average cost of capital for the company.
b) Comoany X is planning to spend large amounts of money on R&D over the next few years and feels that it may not be able to use all the tax-shields generated by a 40% debt ratio. The company considers lowering the debt ratio to 20%. Assume that the lower debt ratio will reduce the before-tax cost of debt to 7.8%. How will this change the WACC?

Explanation / Answer

WACC=wE*rE+wD*rD(1-tC) The proportion =60:40(since the the equity hold 6 million and debt 4 million in that total market value) here rE=.13percent rD=0.8percent, tax=0.35% a)WACC=wE*rE+wD*rD(1-tC) =0.6*0.13+0.4*0.08(1-0.35) =0.078+0.032*0.65 =0.078+0.0208 =0.0988 =9.88% b)if the company lowering dbt ratio by 20%,then the proprtion of debt and equity would be debt=.20 pecent equity=.80percent WACC=wE*rE+wD*rD(1-tC) =0.8*0.13+0.2*0.078(1-0.35) =11.14%

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