QUESTION FOUR

ABC Food, Inc., has a weighted average cost of capital of 10.2 percent. The companys cost of equity is 15 percent, and its pre-tax cost of debt is 6.9 percent. The tax rate is 35 percent.

1. What is the companys target debtequity ratio?

(15 marks)

2. Why do we use an after-tax figure for cost of debt but not for cost of equity?

(3 marks)

PCW, Inc., is all-equity-financed. The expected rate of return on the companys shares is 20 percent.

3. What is the opportunity cost of capital for an average-risk PCW investment?

(5 marks)

4. Suppose the company issues debt, repurchases shares, and moves to a 50 percent debt-to-value ratio (D/V = .50). What will be the companys weighted-average cost of capital at the new capital structure? The borrowing rate is 5 percent and the tax rate is 35 percent. (D+E=V)