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FM – L2 – Q40 – Capital structure

Calculate optimal gearing level and WACC for a company given varying costs of debt, ungeared equity beta, and tax rate.

Question

A company has estimated that its cost of debt capital varies according to the level of gearing, as follows:

Gearing	Cost of debt
20	5.0
30	5.4
40	5.8
50	6.5
60	7.2

Gearing is measured as the market value of the company’s debt as a proportion of the total market value of its equity plus debt.
The rate of tax is 30%. The ungeared equity beta factor for the company is 0.90. The risk-free rate of return is 4% and the return on the market portfolio is 9%.

Required:
Identify the optimal gearing level and WACC.

Answer

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Tags: Capital structure, CAPM, Cost of Equity, Financial Risk, Gearing, Optimal capital structure, Tax shield, Weighted Average Cost of Capital
Level: Level 2

Topic: Capital structure

FM – L2 – Q38 – Cost of capital

Calculate cost of equity and WACC for Akomo Plastics Plc's investment in chemicals manufacturing using CAPM and given beta data.

Question

Akomo Plastics Plc is engaged in plastics manufacture. It is now considering a new investment that would involve diversification into chemicals manufacture, where the business risk is very different from the plastics manufacturing industry.
Research has produced the following information about three companies currently engaged in chemicals manufacturing, in the same part of the industry that Akomo Plastics Plc is planning to invest.

Company	Equity beta	Financed by:
A	2.66	40% equity capital, 60% debt capital
B	1.56	75% equity capital, 25% debt capital
C	1.45	80% equity capital, 20% debt capital

Akomo Plastics Plc is financed by 60% equity capital and 40% debt capital, and would intend to maintain this same capital structure if the new capital investment is undertaken.
The risk-free rate of return is 5% and the return on the market portfolio is 9%. Tax is at the rate of 25%. You should assume that the debt capital of Akomo Plastics Plc and Companies A, B and C is risk-free.

Required
(a) Calculate a suitable cost of equity for the proposed investment by Akomo Plastics Plc in chemicals manufacturing.

(b) Suggest a weighted average cost of capital that should be used to carry out an investment appraisal (NPV calculation) of the proposed project.

Answer

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Tags: Asset beta, Capital structure, CAPM, Chemical manufacturing, Cost of Equity, Equity beta, Financial Risk, investment appraisal, Tax shield, WACC
Level: Level 2

Topic: Cost of capital

Tag (SQ): Tax shield

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FM – L2 – Q40 – Capital structure

Calculate optimal gearing level and WACC for a company given varying costs of debt, ungeared equity beta, and tax rate.

FM – L2 – Q38 – Cost of capital

Calculate cost of equity and WACC for Akomo Plastics Plc's investment in chemicals manufacturing using CAPM and given beta data.

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Tag (SQ): Tax shield

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FM – L2 – Q40 – Capital structure

Calculate optimal gearing level and WACC for a company given varying costs of debt, ungeared equity beta, and tax rate.

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FM – L2 – Q38 – Cost of capital

Calculate cost of equity and WACC for Akomo Plastics Plc's investment in chemicals manufacturing using CAPM and given beta data.

You're reporting an error for "FM – L2 – Q38 – Cost of capital"

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