# UT FIN 320F - 3.8 Capital Structure - Problems (3 pages)

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## 3.8 Capital Structure - Problems

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## 3.8 Capital Structure - Problems

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3
School:
University of Texas at Austin
Course:
Fin 320f - Foundations of Finance
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FIN 320F Foundations of Finance 3 8 Capital Structure Problems 1 A company has two items in its capital structure long term debt and equity The after tax cost of the debt is 5 and the required rate of return on the equity is 15 a Assume the long term debt represents 50 of the total capital structure and the equity represents 50 of the total capital structure What is the Weighted Average Cost of Capital WACC 10 b Assume the long term debt rises to 60 of the total capital structure As a result the equity falls to 40 of the total capital structure What is the WACC 9 c Did the WACC rise or fall when the debt ratio rose by a small amount Why Fall d In part a notice that the WACC is equal to the mean that is the WACC equals the arithmetic average of the two costs Why is that true in part a but not true in part b debt and equity not equal 2 Another company has three capital structure components a long term loan with an after tax cost of 6 some long terms bonds with an average after tax cost of 5 and equity with an expected cost of 18 The loan represents 12 of the total capital the bonds represent 24 of the total and equity represents the remainder What is the company s WACC 13 44 3 A different company has three capital structure components 500 000 that it received by taking out a 15 year mortgage loan 2 500 000 that it obtained when it issued 5 year bonds and 9 000 000 in total equity a How much total capital does the firm have 12 000 000 b What is each component s proportion to the total 0 042 loan 0 208 bonds 0 75 equity tmpkuvm5ez6 Page 1 of 3 Heidi Toprac 2017 FIN 320F Foundations of Finance 3 8 Capital Structure Problems c The loan costs 7 after tax the bonds cost 9 after tax and the estimated cost of the equity is 16 What is the company s WACC 14 166 4 Let s review a If a corporation has no debt what is its WACC 16 b If it adds a little debt what happens to both the WACC and the value of the firm WACC falls value rises c If it adds too much debt what happens to both the WACC and the value of the firm WACC rises Value falls d How does a corporation know when debt is not too high and not too low but just right WACC minimized e How do we measure the value of the corporation See slide 5 from Unit 2 6 How big is that company Stock price x Number of stocks f What is the goal of the corporation See slide 9 from Unit 2 1 What is the goal of the corporation Maximize shareholder s proft 5 Pulling it all together The discount rate on a 30 day T Bill is 0 25 The stock market is expected to earn 10 during the coming year A company with a of 1 5 has two sources of capital 750 000 in long term debt for which it pays an after tax cost of 4 and 1 250 000 in equity What is the company s WACC Stumped There are hints below but don t peek unless you must 10 8 tmpkuvm5ez6 Page 2 of 3 Heidi Toprac 2017 FIN 320F Foundations of Finance 3 8 Capital Structure Problems Use the CAPM formula to find the cost of equity Follow the process from 3b to find the proportions Finish up with the WACC formula tmpkuvm5ez6 Page 3 of 3 Heidi Toprac 2017

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