Ch 16 B4_Correct

Ch 16 B4_Correct - = (1 - 0.25) 17% + 0.25 (1 - 0.40) 9% =...

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Chapter 16 The solution for Chapter 16 problem B4 uses the wrong required return for equity in computing the WACC when L = 50%. PROBLEM B4: ACE Corp. has identified two alternative capital structures. If the firm borrows 25% of the value of the firm, it can borrow the money at r d = 9%, and the shareholders will have a required return of r e = 17%. If the firm borrows 50% of the value of the firm, it can borrow the money at r d = 11%, and the shareholders will have a required return of r e = 20.82%. ACE pays corporate taxes at the rate of 40%. Which capital structure should ACE adopt? If ACE is operating in an essentially perfect capital market except for taxes, are the taxes approximately symmetric, or are they asymmetric? BOOK SOLUTION : B4. WACC = (1 - L) r e + L (1 - T) r d WACC L=25%
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Unformatted text preview: = (1 - 0.25) 17% + 0.25 (1 - 0.40) 9% = 14.10% WACC L=50% = (1 - 0.50) 21.6% + 0.50 (1 - 0.40) 11% = 14.10% The choice of capital structure does not matter . Taxes are approximately symmetric because using a different proportion of debt does not result in a different WACC. However, if you look at the problem in the textbook, it states that when L = 50% that r e = 20.82% and r d = 11%. CORRECTED SOLUTION: WACC L=25% = (1 - 0.25) 17% + 0.25 (1 - 0.40) 9% = 14.10% WACC L=50% =(1 – 0.50) 20.82% + 0.50 ( 1 – 0.40) 11% = 10.41 + 3.3 = 13.71% In this case, choice of capital structure DOES matter . The firm should choose leverage at 50% because this minimizes their WACC. Taxes are therefore asymmetric because the WACC changes with different proportions of debt....
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This note was uploaded on 09/18/2011 for the course FIN 303 taught by Professor Bernile during the Spring '11 term at University of Miami.

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