Hi There,

I just got feedback from an assignment I submitted and got answer (b). of the following question incorrect. I have left my answer there so that you can see where I have gone wrong.

Could you please assist me in getting the correct answer and showing how to work that out.

Thank you so much, in advance!

Question 5

Environ4Us Ltd has the following capital structure.

Value Cost of Fund

Debt 120,000,000 3.5%

Equity 180,000,000 11.0%

(a)Calculate the weighted average cost of capital for Environ4Us Ltd.

Weighted Average Cost of Capital = proportion of equity x cost of equity + proportion of debt x after tax cost of debt

Total Capital = Equity + Debt

180,000,000 +120,000,000 = 300,000,000

Proportion of equity = (180,000,000 / 300,000,000) = 0.6

Proportion of debt = (120,000,000 / 300,000,000) = 0.4

Cost of equity = 11 %

Cost of debt = 3.5%

WACC = (0.6 x 11%) + (0.4 x 3.5%)

= 6.6% + 1.4 %

= 8.0%

Environ4Us Ltd is planning to restructure. This will involve buying back $100,000,000 worth of shares and selling $100,000,000 worth of bonds (debt).

(b)Calculate the weighted average cost of capital for Environ4Us Ltd after the firm has changed their capital structure.

Buying back the shares increases the shareholders ownership and therefore the equity. In this case, the shareholders equity will increase by 100,000,000 to make it 280,000,000.

On the other hand, selling the bonds decreases the company's debt. In this case the debt will decrease by 100,000,000 to make it 20,000,000.

WACC = (r_d * D / D +E) + (r_e * E / D + E)

Where:

r_d = the cost of debt capital

r_e = the cost of equity capital

D = the total value of debt finance used by the company

E = the total value of equity finance used by the company

With no change in the respective costs, the WACC will now be:

= (280,000,000 / 300,000,000) x 11% + (20,000,000 / 300,000,000) x 3.5%

= (0.93333 x 11%) + (0.06667 x 3.5%)

= 10.27% + 0.23%

= 10.50%