08-19-2010, 05:17 PM
Dear Flora,
The solution, of all queries, provided by you is incorrect, although some of the logics have correctly been applied.
You have calculated interest on EBIT rather than value of debt, although you applied the correct rate of 18% rather than 15%.
Logically, cost of debt is given i.e. 15%, however, 18% is relevant is this case, since value of debt is given, which means market value of debt, which indicates that book value of debt is higher than market value, so the effective rate of interest will be higher which is already given i.e. 18%. Had it not been given it would have been calculated.
Reply to your queries is given below.
<b>1- Market value of Firm's Equity.</b>
EBIT -------------------400,000
Less Interest----------- 36,000 (200,000*18%)
EBT --------------------364,000
Less Tax----------------127,400
Profit to Equity Holders---236,600
Cost of Equity ------------ 21% (Equity capitalization rate)
Market value of equity ---1,126,667 (Profit/Equity Rate)
<b>2- Market price per share.</b>
The way in which you ascertained market price is correct, however your answer is incorrect due to incorrect figures.
Correct answer should be 11.267 i.e. MV of Equity/ No. Of shares or 1,126,667/100,000.
The following is an alternative technique to arrive at the same answer.
Market price per share = EPS * PE ratio
Where EPS is --- 236,600/100,000 = 2.366 and
PE ratio is ------- 1/Ke ----- 1/21% = 4.762 (since PE is reciprocal of Ke)
Market Value per share is ------2.366*4.762 = 11.267
<b>3- Firm's total market value</b>
Market Value of equity-------1,126,667
Market Value of Debt -------- 200,000
Market value of firm.---------1,326,667
<b>4- Firm's weighted average cost of capital</b>
Weighted Cost of equity ------ 21% * 1,126,667/1,326,667 =17.83%
Weighted Cost of debt -------- 18%*65%(100% - 35%tax)* 200,000/1,326,667 =1.763
Weighted Average cost of capital ---- 19.6%
Let me know if confusion still exists.
Best Regards,
Faisal.
The solution, of all queries, provided by you is incorrect, although some of the logics have correctly been applied.
You have calculated interest on EBIT rather than value of debt, although you applied the correct rate of 18% rather than 15%.
Logically, cost of debt is given i.e. 15%, however, 18% is relevant is this case, since value of debt is given, which means market value of debt, which indicates that book value of debt is higher than market value, so the effective rate of interest will be higher which is already given i.e. 18%. Had it not been given it would have been calculated.
Reply to your queries is given below.
<b>1- Market value of Firm's Equity.</b>
EBIT -------------------400,000
Less Interest----------- 36,000 (200,000*18%)
EBT --------------------364,000
Less Tax----------------127,400
Profit to Equity Holders---236,600
Cost of Equity ------------ 21% (Equity capitalization rate)
Market value of equity ---1,126,667 (Profit/Equity Rate)
<b>2- Market price per share.</b>
The way in which you ascertained market price is correct, however your answer is incorrect due to incorrect figures.
Correct answer should be 11.267 i.e. MV of Equity/ No. Of shares or 1,126,667/100,000.
The following is an alternative technique to arrive at the same answer.
Market price per share = EPS * PE ratio
Where EPS is --- 236,600/100,000 = 2.366 and
PE ratio is ------- 1/Ke ----- 1/21% = 4.762 (since PE is reciprocal of Ke)
Market Value per share is ------2.366*4.762 = 11.267
<b>3- Firm's total market value</b>
Market Value of equity-------1,126,667
Market Value of Debt -------- 200,000
Market value of firm.---------1,326,667
<b>4- Firm's weighted average cost of capital</b>
Weighted Cost of equity ------ 21% * 1,126,667/1,326,667 =17.83%
Weighted Cost of debt -------- 18%*65%(100% - 35%tax)* 200,000/1,326,667 =1.763
Weighted Average cost of capital ---- 19.6%
Let me know if confusion still exists.
Best Regards,
Faisal.
