Question

Ignacio, Inc., had after-tax operating income last year of $1,197,000. Three sources of financing were used by the company: $2 million of mortgage bonds paying 4 percent interest, $4 million of unsecured bonds paying 6 percent interest, and $9 million in common stock, which was considered to be relatively risky (with a risk premium of 8 percent). The rate on long-term treasuries is 3 percent. Ignacio, Inc., pays a marginal tax rate of 30 percent.
Required:
1. Calculate the after-tax cost of each method of financing. Enter your answers as decimal values rounded to three places. For example, 4.36% would be entered as ".044".
Mortgage bonds
Unsecured bonds
Common stock
2. Calculate the weighted average cost of capital for Ignacio, Inc. Round intermediate calculations to four decimal places. Round your final answer to four decimal places before converting to a percentage. For example, .06349 would be rounded to .0635 and entered as "6.35" percent.
___________%
Calculate the total dollar amount of capital employed for Ignacio, Inc.
$___________
3. Calculate economic value added (EVA) for Ignacio, Inc., for last year. If the EVA is negative, enter your answer as a negative amount.
$ ___________
Is the company creating or destroying wealth?
Destroying
4. What if Ignacio, Inc., had common stock which was less risky than other stocks and commanded a risk premium of 5 percent? How would that affect the weighted average cost of capital?
Lower
What is the new EVA? In your calculations, round weighted average percentage cost of capital to four decimal places. If the EVA is negative, enter your answer as a negative amount.
$ ____________

Answer 1

Answer:

1) For cost of Mortgage Bonds(post tax): $0.04 * (1 - 0.3)$=

$0.04 * 0.7 = 0.028$

For cost of Unsecured Bonds(post tax) : $0.06 * (1 - .3)$=

$0.06 * 0.7 = 0.042$

For cost of Stock (using CAPM Model)

= Risk free Rate + Risk Premium

= 0.03 +0.08 = 0.110

2) Weighted Average Cost of Capital =$\frac{(2 * 0.028) + (4*0.042) + (9*0.11)}{(2+4+9)}$

= 0.0809

3. Economic Value Added

Operating Income after Tax = $1,197,000

Less : Cost of Capital= [(2,000,000 + 4,000,000 + 9,000,000) * 0.0809] = $1,213,500

Economic Value Added =

($1,197,000 - $1,213,500) = $ 405,500

4. If Risk premium is 5%:

Revised Cost of Stock = (0.03 + 0.05 ) 0.08

Therefore, Revised WACC =

$\frac{(2 * 0.028) + (4*0.042) + (9*0.08)}{(2+4+9)}$

= 0.0629

If gnacio, Inc., had common stock which was less risky than other stocks and commanded a risk premium of 5%, the WACC would be lower.

Revised EVA will be:

Operating Profit After Tax = $ 1,197,000

Cost of Capital :

[(2,000,000 + 4,000,000 + 9,000,000) * 0.0629] = $934,500

Economic Value Added = $262,500.