Brown Inc. has a capital structure consisting of $5,000,000 in long-term debt and $15,000,000 in common equity. The interest rate paid on the long-term debt is 7.5%. Brown Inc. is in the 35% tax bracket. On the common equity (stock) the firm pays an annual dividend of $1.10 and it expects to grow the dividend by 15 % per year for the foreseeable future. The stock is currently selling for $22 per share.
1. Calculate Brown Inc's weighted average cost of capital .
2. If Brown Inc. were to increase the percentage of debt in the capital structure what would happen to the cost of capital. (No calculations required).
3. Identify and explain one risk of financing with debt.
1. Cost of debt rd= interest rate*(1-Tax rate)=7.5%*(1-35%)=4.875%
Cost of equity re= D0*(1+g)/P0+g=1.1*(1+15%)/22+15%=20.75%
Proportion of debt wd= 5000000/(5000000+15000000)=0.25
Proportion of equity ...
Instructional aid on how to calculate the weighted average cost of capital is provided. The risks of financing with debt are also explained.