Tutorial 9

Question 1

10/648:

Rover Corporation Ltd has a debt/equity ratio of 0.60. It’s WACC is 15%, and its cost of debt is 12%

a. Ignoring taxes, what is Rover’s cost of equity?
b. What would Rover’s cost of equity be if the debt/equity ratio were 1.0
c. what is Rover’s WACC in part (b)?

Answer 1

a RE = 0.15 + (0.15 – 0.12)(0.6) = 16.8%

b RE = 0.15 + (0.15 – 0.12)(1) = 18%

c WACC = 0.5(0.18) + 0.5(0.12) = 15%

Question 2

13/648

The Muddle Co Ltd expects an EBIT of $5000 every year forever. Muddlge can borrow at 9%. Muddlge currently has no debt, and its cost of equity is 20%. If the company tax rate is 30%, what is the value of the firm? What will the value be if Muddle borrows $5000 and uses the proceeds to reduce the number of shares

Answer 2

VU = 5000(0.7)/0.20 = 17 500
VL = 17 500 + 0.30(5000) = 19 000

Question 3

15/648

Rig Real Estate Ltd currently uses no debt. EBIT is expected to be $9,000 forever, and the cost of capital is currently 15%. The corporate tax rate is 30%

a. What is the market value of Rig Real Estate?
b. Suppose Rig floats a$30,000 debt issue and uses the proceeds to reduce share capital. the interest rate is 10%. What is the new value of the business? What is the new value of the equity?

Answer 3

a VU = 9000(0.7)/0.15 = 42 000

b VL = 42 000 + 0.3(30 000) = $51 000
E = 51 000 – 30 000 = $21 000