FINANCE

1.              Suppose the weighted average cost of capital of the Gadget Company is 10%. If Gadget has a capital structure of 50% debt and 50% equity, a before-tax cost of debt of 5%, and a marginal tax rate of 20%, then its cost of equity capital is

The below problem relates to question 2, 3, 4 and 5 below. You can incorporate all responses on one Excel spreadsheet

Barbara Andrade is an equity analyst who covers the entertainment industry for Greengable Capital Partners, a major global asset manager. Greengable owns a significant position with a large unrealized capital gain in Mosely Broadcast Group (MBG). On a recent conference call, MBG’s management states that they plan to increase the proportion of debt in the company’s capital structure. Andrade is concerned that any changes in MBG’s capital structure will negatively affect the value of Greengable’s investment. To evaluate the potential impact of such a capital structure change on Greengable’s investment, she gathers the information about MBG given in Exhibit A.

 

EXHIBIT A Current Selected Financial Information for MBG

Yield to maturity on debt 8.00%
Market value of debt $100 million
Number of shares of common stock 10 million
Number of shares of common stock $30
Cost of capital if all equity-financed 10.3%
Marginal tax rate 35%
   

 

Andrade expects that an increase in MBG’s financial leverage will increase its costs of debt and equity. Based on an examination of similar companies in MBG’s industry, Andrade estimates MBG’s cost of debt and cost of equity at various debt-to-total capital ratios, as shown in Exhibit B.

 

EXHIBIT B Estimates of MBG’s Before-Tax Costs of Debt and Equity

 

Debt-to-Total Capital Ratio Cost of Debt Cost of Equity
20% 7.7% 12.5%
30% 8.4% 13.0%
40% 9.3% 14.0%
50% 10.4% 16.0%

 

 

2.              MBG is best described as currently: A. 25% debt financed and 75% equity financed. or B. 33% debt financed and 66% equity financed. or C. 75% debt financed and 25% equity financed.

 

3.              Based on Exhibits A and B, the current after-tax cost of debt for MBG is:

 

Current after-tax cost of debt = 5.2%

 

 

4.                Based on Exhibits A and B, MBG’s current cost of equity capital is:

Current Cost of Equity Capital = 10.3%

 

5.              Based on Exhibits A and B, what debt-to-total capital ratio would minimize MBG’s weighted average cost of capital? A. 20% or. B. 30%. or C. 40%.

 

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