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Chapter 7

Example 2

X Co is identical in all operating and risk characteristics to Y Co, except that X
Co is financed only by equity valued at $3m whereas Y Co has debt valued at
$0.9m (based on market value) as part of its capital structure. X Co and Y Co
both operate in a country where tax is payable at 33%.

The interest paid on Y Co’s debt is $72,000 per annum, and it pays a dividend
to shareholders of $401,760 per annum. X Co pays an annual dividend of
$450,000.

Required:

(a) Calculate the value of the equity of Y Co.

(b) Calculate the cost of capital for X Co.

(c) Calculate the cost of equity for Y Co, and the cost of debt for Y Co.

(d) Calculate the weighted average cost of capital for Y Co.

Solution

(a) V g = V u + TB, so given that T = 0.33,

V g = 3,000,000 + (33% × 900,000) = $3,297,000

so the value of the equity = 3,297,000 – 900,000 (value of debt) =
$2,397,000

(b) Assuming no growth in dividends, using the dividend valuation model,

k eu = Dividend/V E = 450,000/3,000,000 = 15%

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