W4 - WACC & Capital Structure

Question 1

WACC basics

Answer 1

Capital raised by equity or debt
Each carries a cost

When we combine the costs of all forms of finance, the weighted
average signifies the risk adjusted rate of return required.

Company needs to generate returns in excess of cost of capital in
order to increase value

Thus cost of capital used as the minimum required return in project
appraisal

Question 2

Why debt is more favourable than equity

Answer 2

Interest on debt is tax-deductible, but dividend payments are not.

Question 3

Working out ROE

Answer 3

Return on Equity

Say equity in Case A is £1000, no debt.
EBIT: £100
Tax: (25)
Net Income: £75
ROE: 75/1000 = 7.5%

Case B, £500 EQUITY £500 DEBT AT 8%
EBIT: £100
Interest (500 x 8%): (40)
Earnings before tax: £60
Tax: (15)
Net Income: £45
ROE: 45/500 = 9%