CMA Study Group

WACC Help

  • 1.  WACC Help

    Posted 16 days ago
    Hello, can someone please help me understand the question below, i got it right, but i just did my best guess.

     
     
    Question: 35 A company is in the process of considering various methods of raising additional capital to grow the company. The current capital structure is 25% debt totaling $5 million with a pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%. The marginal income tax rate is 40%. The company's policy is to allow a total debt to total capital ratio of up to 50% and a maximum weighted-average cost of capital (WACC) of 10%. The company has the following options.
    1. Option 1: Issue debt of $15 million with a pre-tax cost of 10%.
    2. Option 2: Offer shares to the public to generate $15 million. The cost of equity is 10%.
    Which option should the company select?
    Answer (A) is correct.
    Before considering any options, the total capital is $20 million ($5 million ÷ 25%) and equity is $15 million ($20 million total capital – $5 million debt). If the company issues $15 million in debt, the capital structure will consist of 57% debt and 43% equity, which exceeds the 50% debt to total equity limit. If the company issues $15 million in stock, the capital structure will consist of 14% debt and 86% equity with a WACC of 9.44% {[14% × 10% × (1 – 40%)] + [86% × 10%]}. Thus, the company should choose Option 2 because it meets all requirements.


    If the company originally starts with Debt of 5mil 25% and equity of 15 mil 75%, how does issuing 15 million in debt change the structure to 57% and 43%.  Isn't 15 million debt plus 5 million of debt equal 20 million?  Do i disregard the the original capital structure?

    Thanks!

    ------------------------------
    Reginald-Chris
    Accountant
    Haddon Heights NJ
    United States
    ------------------------------


  • 2.  RE: WACC Help

    Posted 15 days ago
    Hi chris,

    (If the company originally starts with Debt of 5mil 25% and equity of 15 mil 75%, how does issuing 15 million in debt change the structure to 57% and 43%.  Isn't 15 million debt plus 5 million of debt equal 20 million?  Do i disregard the the original capital structure?)

    Yes you are right the debt will be 20mn but capital structure also include equity of 15mn. So
    we need to also consider equity.

    Weight of debt=
    5mn+15mn÷5mn(debt)+15mn(debt)+15m(Equity)
    =20mn/35mn
    =57.14%.

    We need to just add the new issue in previous capital.

    Hope this help.





    ------------------------------
    Prajnya Shetty
    GL Executive in XPO Logistics
    India.
    ------------------------------



  • 3.  RE: WACC Help

    Posted 15 days ago

    Hello Reginal,

    The company already has $5million debt and $15 million equity. <o:p></o:p>

    Option 1: After issuing an additional debt $15 million, the new capital structure of $35 million will consist of $20 million debt and $15 million equity; same as 57% debt and 43% equity.<o:p></o:p>



    ------------------------------
    Felix Lawson
    Finance Officer
    Kenya
    ------------------------------



  • 4.  RE: WACC Help

    Posted 15 days ago
    Hi Reginald-Chris, the current capital structure for this company is debt at $5,000,000 (25%) and equity at $15,000,000 (75%) totaling $20,000,000.  This meets the company's requirement of a total debt to total capital ratio of up to 50% (they are currently at 25%).  With a debt pretax cost of 10% and a marginal income tax rate of 40%, the weighted average after tax cost of debt is 1.5% (.1*(1-.4)*.25=.015).  With an equity cost of 10%, the weighted average cost of equity is 7.5% (.1*.75=.075).  Adding the weighted averages of both debt and equity total 9% (.015+.075=.09).  This also meets the company's requirement of not exceeding a 10% WACC.

    With Option 1, issuing debt of $15,000,000 will increase the debt total to $20,000,000 ($15,000,000 new+$5,000,000 current).  Debt of $20,000,000 plus equity of $15,000,000 is a total of $35,000,000.  The total debt to total capital ratio has now increased to 57.14% ($20,000,000/$35,000,000).  Because this new total debt to total capital ratio exceeds the company's maximum total debt to total capital ratio of 50%, there is no need to calculate the WACC for this option, as this option does not fulfill one of the company's requirements.  I believe that you are thinking that the company will only have debt in their capital structure under Option 1.  The question states that the company is "considering various methods of raising additional capital" so Option 1 will still include equity in their capital structure.  I hope this explains why the total amount of capital in Option 1 is $35,000,000, not $20,000,000.  With a debt increase of $15,000,000, the total debt to total capital ratio will increase from 25% to 57.14%.

    With Option 2, issuing equity of $15,000,000 will increase the equity total to $30,000,000 ($15,000,000 new+$15,000,000 current).  Current debt of $5,000,000 plus equity of $30,000,000 is a total of $35,000,000.  The total debt to total capital ratio has now decreased to 14% ($5,000,000/$35,000,000).  This fulfills one of the company's requirements (total debt to total capital ratio cannot exceed 50%), so we now need to calculate the WACC to ensure it will meet the company requirement of not exceeding 10%.  The after tax cost of debt is 0.84% (.1*(1-.4)*.14=.0084).  The cost of equity is 8.6% (.1*.86=.086).  Adding the weighted averages of both debt and equity total 9.44% (.0084+.086=.0944).  This also meets the company's requirement of not exceeding a 10% WACC.

    I hope this explanation helps!

    ------------------------------
    Lori Klay
    Senior Accountant
    Indianapolis, IN
    United States
    ------------------------------