Using the information from the two previous problems, what is the Capital Struct

Question

Using the information from the two previous problems, what is the Capital Structure mix on a dollar value basis for the BA707 and AB300 companies?

(Previous Problem - The BA720 Company has $15 million in pretax income, a tax rate of 30%, and a capital structure mix that is comprised of 78% in equity and 22% million in long term debt [market value basis]. The cost of debt is 9% and cost of equity is 12%.

a) What is the company’s weighted average cost of capital?

b) What is the value of the company?

The AB300 Company is identical to the BA720 Company (information in previous problem) in every respect save two: it is debt free and its cost of equity is 11.5%.

a) What is the value of the AB300 Company?

b) Explain the difference in values for AB300 versus BA320.)

Explanation / Answer

a) WACC = wd(rd)(1 – T) + wc(rs)

= 0.22 * 9 * ( 1 - 0.3) + 12*0.78 = 10.746%

b) value of firm = pretax income* ( 1 - tax rate)/WACC = 15*( 1 - 0.3)/.10746 = 97.71m

a) value of firm = pretax income* ( 1 - tax rate)/cost of equity = 15*( 1 -0.3)/.12 = 87.5m

b) Difference is because first firm has lower cost of capital compared to other firm. Firm cash flows for the second one is being discounted at a higher rate compared to first causing value to be lower.

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