Reference no: EM132781268
Problem - Barbara Andrade is a generalist in equity analysis for Greengable Capital Partners, a major global asset manager. The investment committee relies on her input for a variety of equity recommendations. Because she has a background as an analyst in the finance department of an entertainment company, she is often asked to evaluate a variety of issues relating to that industry.
Greengable owns a significant Position with a large gain in Mosely Broadcast Group. On a regular quarterly conference call, Brian Hunsaker, Greengable's growth portfolio manager, feels that Mosely's CFO may adjust the company's capital structure to include more debt. Concerned that any changes in the capital structure will impact the value of Greengable's holdings, Hunsaker asks Andrade to evaluate the impact of such a change.
To begin the analysis, Andrade ?rst compiles the following current information relating to Mosely:
Yield to maturity on debt 8%
Market Value of debt $100 million
Number of shares of common stock 10 million
Price per share of common stock $30
Weighted Average cost of capital 10.82%
Marginal Tax rate 35%
The above data results in higher costs of both debt and equity to reflect increased credit risk and more financial leverage. Based on comparisons with similar companies in the industry, Andrade estimates that for the following debt to total capital ratios, the corresponding cost of debt and cost of equity will be:
|
Debt to total capital ratio (%)
|
Cost of debt (%)
|
Cost of Equity (%)
|
|
20
|
7.7
|
12.5
|
|
30
|
8.4
|
13
|
|
40
|
9.3
|
14
|
|
50
|
10.4
|
16
|
Required -
1. What is the after tax cost of debt?
2. What is the cost of equity capital?
3. Determine the debt to total capital ratio that would minimize Moseiy's weighted average cost of capital (WACC), Justify and analyze your answer.