Calculate Touring Enterprises' weighted average cost of capital (WACC).
Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity.
WACC = E/V x Re + D/V x Rd x (1 - Tc)
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = firm value
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Cost of equity 5%
Cost of debt 10%
Total Equity- 7 million
Total debt- 18 million
Total 25 million
Determine the weightings of debt and equity in the capital structure.
Equity -28% (7 divided by 25)
Debt- 72%
Using your answers to the above questions, calculate the WACC
WACC = E/V x Re + D/V x Rd x (1 - Tc )
(7/25) x 5% + (18/25) x 10% x (1- .35)= 6.08%
If Touring Enterprises were to increase the percentage of debt in its capital structure, what would happen to the WACC?
The WACC would decline as debt financing is cheaper overall than equity financing. Furthermore, equity finances a large portion of the company. By increasing the cheaper debt financings, the overall WACC is lower as the equity portion declines.
Identify and explain the benefits and risks of debt financing.
Debt financing allows the business to have more control. The business does not have investors or partners to answer to. The business owns all the profit you make. If the company finances the business using debt, the interest you repay on your loan is tax-deductible. This means that small businesses are shielded, in some respects, from certain taxes and lowers your tax liability every year. Your interest is usually based on the prime interest rate. The lender from whom the company borrows money from does not share in the profits. In the instance of the above example, the company is more than double financed through debt than through equity. The company, although it pays a larger percentage to bond holders, is maintaining the ownership claim to earnings...
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