Optional Practice Questions
Class 14
ANSWERS
Practice Question #1
Delta Corp. has a current capitalization of $1 million with a debttoequity ratio of .55 and an ROA of 13%.
Their interest payment on their current debt is $17,740 per year and they have a 40% corporate tax rate.
a.
What is Delta’s current weighted average cost of capital?
First compute the weights of debt and equity (I start with debt):
If
$1million – Amount of Debt = Amount of Equity, then
�
$
������
= .55
⇒
1.55D = $550,000
⇒
Debt = $354,839 and Equity = $645,161
($1million – $354,839)
Next compute the Cost of Debt:
r
�
=
��������
����
=
��
,
���
���
,
���
= .05 = 5%
Using MM Prop2, the Cost of Equity is:
𝑟
�
=
𝑟
�
+ (
𝑟
�
− 𝑟
�
)
�
�
= .13 + (. 13
−
.05). 55 = .1740 = 17.4%
Putting all the components together:
𝑊𝐴𝐶𝐶
= .174
∗
645,161
1,000,000
+ .05
∗
354,839
1,000,000
∗
(1
−
.40) = .1229 = 12.29%
b.
If Delta needs to expand at a cost of $500,000 and funds the expansion with bonds at 8% interest (current 1year
Tbills are yielding 5%), what is their new WACC?
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 Fall '08
 SMITH
 Debt, Interest, Weighted average cost of capital, North Pole, South Pole

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