91Ó°ÊÓ

Evans Technology has the following capital structure:

Debt ............................................ 40%

Common equity .......................... 60

The aftertax cost of debt is 6 percent, and the cost of common equity (in the form of retained earnings) is 13 percent.

a. What is the firm’s weighted average cost of capital?

b. An outside consultant has suggested that because debt is cheaper than equity, the firm should switch to a capital structure that is 50 percent debt and 50 percent equity. Under this new and more debt-oriented arrangement, the aftertax cost of debt is 7 percent, and the cost of common equity (in the form of retained earnings) is 15 percent. Recalculate the firm’s weighted average cost of capital.

c. Which plan is optimal in terms of minimizing the weighted average cost of capital?

Step by step solution

01

Meaning of Cost of Capital

Cost of capital is used in finance management and refers to the minimum return a business entity needs to create to cover the costs incurred in the capital project.

02

Calculation of weighted average cost of capital

Particular	Cost after tax	Weights	Weighted Cost
Debt	6%	40%	2.40%
Common equity	13%	60%	7.80%
Weighted average cost of capital	10.20%

03

Calculation of new weighted average cost of capital

Particular	Cost after tax	Weights	Weighted Cost
Debt	7%	50%	3.50%
Common equity	15%	50%	7.50%
Weighted average cost of capital	11%

04

 Explanation

In the first scenario, we find the weighted average cost of capital is 10.20%, less than the second scenario's weighted average cost of capital is 11%. So, the first plan is optimal in terms of the weighted average cost of capital.

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