Example 174

The Cost of Equity and the Value of the Firm

This is a comprehensive example that illustrates most of the points we have discussed thus far. You are given the following information for the Format Co.:

The cost of debt capital is 10 percent. What is the value of Format's equity? What is the cost of equity capital for Format? What is the WACC?

This one's easier than it looks. Remember that all the cash flows are perpetuities. The value of the firm if it has no debt, VU, is:

RU RU

From M&M Proposition I with taxes, we know that the value of the firm with debt is:

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CHAPTER 17 Financial Leverage and Capital Structure Policy 583

Because the firm is worth $670 total and the debt is worth $500, the equity is worth $170:

Based on M&M Proposition II with taxes, the cost of equity is:

= .20 + (.20 - .10) X ($500/170) X (1 - .34) = 39.4%

Finally, the WACC is:

WACC = ($170/670) X 39.4% + (500/670) X 10% X (1 - .34) = 14.92%

Notice that this is substantially lower than the cost of capital for the firm with no debt (RU = 20%), so debt financing is highly advantageous.

Ross et al.: Fundamentals VI. Cost of Capital and 17. Financial Leverage and of Corporate Finance, Sixth Long-Term Financial Capital Structure Policy

Edition, Alternate Edition Policy

The Cost of Equity and the WACC: M&M Proposition II with Taxes

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