Southwest Tours currently has a weighted average cost of capital of 11.3 percent

Question

Southwest Tours currently has a weighted average cost of capital of 11.3 percent based on a combination of debt and equity financing. The firm has no preferred stock. The current debt-equity ratio is 0.58 and the aftertax cost of debt is 6.4 percent. The company just hired a new president who is considering eliminating all debt financing. All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm?

Select one:

a. 12.62 percent

b. 12.89 percent

c. 13.37 percent

d. 14.14 percent

e. 11.45 percent

Which one of the following will increase the cost of equity, all else held constant?

Select one:

a. Increase in stock price

b. Decrease in future dividends

c. Decrease in beta

d. Increase in the dividend growth rate

e. Decrease in market risk premium

Explanation / Answer

DEBT EQUITY RATIO = 0.58

WEIGHT OF DEBT

= 0.58 / 1.58

= 0.3671

WEIGHT OF EQUITY

= 1 - 0.3671

= 0.6329

WACC = 11.3%

0.3671 * 6.4% + 0.6329 * COST OF CAPITAL = 11.3%

2.349% + 0.6329 * COST OF CAPITAL = 11.3%

0.6329 * COST OF CAPITAL = 8.951%

COST OF CAPITAL = 14.14%

ANSWER OPTION D

----------------------------------------------------------------------------------------------------------------------------------------------------------------

INCEREASE IN THE DIVIDEND GROWTH RATE WILL INCEREASE THE COST OF EQUITY ALL ELSE HELD CONSTANT.

COST OF EQUITY = (FUTURE DIVIDEND / CURRENT PRICE) + GROWTH

FROM THE ABOVE EQUATION IT CAN BE UNDERSTOOD THAT IF GROWTH RATE INCEREASED AUTOMATICALY THE COST OF EQUITY WILL GET INCEREASED.

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