CMA Study Group

A company is in the process of considering various methods of raising additional capital to grow the company. The current capital structure is 25% debt totaling $5 million with a pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%. The marginal income tax rate is 40%. The company's policy is to allow a total debt to total capital ratio of up to 50% and a maximum weighted-average cost of capital (WACC) of 10%. The company has the following options.

Option 1: Issue debt of $15 million with a pre-tax cost of 10%.

Option 2: Offer shares to the public to generate $15 million. The cost of equity is 10%.

Which option should the company select?

a. Option 1 because it has the lower WACC of 7.72%.

b. Option 1 because the equity to total capital ratio will be 43%.

c. Option 2 because the equity to total capital ratio will be 86%.

d. Either Option 1 or 2 because both will yield a WACC of 10%.

Debt:Equity

25%:75%

5,000,000/.25=20,000,000 Total Capital.

Raising 15,000,000 with DEBT would raise the debt ratio to 57.14%

20,000,000/35,000,000=0.5714

And WACC will be

57.14% x 6% + 42.86 x 10%

=0.3428+0.4286

= 7.72%.. Since Company requirement is Debt should not be more than 50% .

Correct Answer is Option 2. Calculations as follow;

30,000,000/35,000,000=85.71% of Equity

And WACC is

14.29% x 6% + 85.71% x 10%

=0.85 % + 8.57 %

= 9.42%

Ratio of Debt is less than 50% and WACC is 9.42 % which is less than 10%

A company is in the process of considering various methods of raising additional capital to grow the company. The current capital structure is 25% debt totaling $5 million with a pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%. The marginal income tax rate is 40%. The company's policy is to allow a total debt to total capital ratio of up to 50% and a maximum weighted-average cost of capital (WACC) of 10%. The company has the following options.

Option 1: Issue debt of $15 million with a pre-tax cost of 10%.

Option 2: Offer shares to the public to generate $15 million. The cost of equity is 10%.

Which option should the company select?

a. Option 1 because it has the lower WACC of 7.72%.

b. Option 1 because the equity to total capital ratio will be 43%.

c. Option 2 because the equity to total capital ratio will be 86%.

d. Either Option 1 or 2 because both will yield a WACC of 10%.

A company is in the process of considering various methods of raising additional capital to grow the company. The current capital structure is 25% debt totaling $5 million with a pre-tax cost of 10%, and 75% equity with a current cost of equity of 10%. The marginal income tax rate is 40%. The company's policy is to allow a total debt to total capital ratio of up to 50% and a maximum weighted-average cost of capital (WACC) of 10%. The company has the following options.

Option 1: Issue debt of $15 million with a pre-tax cost of 10%.

Option 2: Offer shares to the public to generate $15 million. The cost of equity is 10%.

Which option should the company select?

a. Option 1 because it has the lower WACC of 7.72%.

b. Option 1 because the equity to total capital ratio will be 43%.

c. Option 2 because the equity to total capital ratio will be 86%.

d. Either Option 1 or 2 because both will yield a WACC of 10%.