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The total value of a Guess Co. is $3,000,000 and it has $600,000 debt. The cost...

The total value of a Guess Co. is $3,000,000 and it has $600,000 debt. The cost of debt is 6.75% and the cost of equity is 15%. What is the weighted-average cost of capital (WACC)?
The before-tax cost of debt for Guess Co. is 6.75% and the marginal tax rate is 20%. What is the after-tax cost of debt for the firm?
What is the after-tax cost of capital for Guess Co.?
Guess Co. is considering issuing additional stock to an investor and retiring the debt. Should they?
What is the current prime rate? If a company can borrow at Prime plus 2%, what is its cost of capital?

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Answer #1

Given total value of firm= $3,000,000 and debt= $600,000

So Equity= $3,000,000 - $600,000 = $2400000

Thus the Weight of debt (Wd) = $600,000 / $3,000,000

=20%

& Weight of Equity We = 80%

Also given Cost of debt (Rd) = 6.75% & Cost of Equity (Re )= 15%

So the weighted-average cost of capital (WACC) without considering the effect of Tax will be given by:

WACC= Wd * Rd + We * Re

= 20% x 6.75% + 80% * 15%

= 13.35%

Part 2.

Now given Tax rate (T) = 20%

So the after tax cost of debt is given by the formula

rg(1 – T)

= 6.75 % ( 1-20%)

= 5.40%

Part 3.

Now using this after tax cost of debt, the after tax cost of captial will be:

= 5.4%*20% + 15%*80%

= 13.08%

Part 4.

No they should not issue additional stock by retiring debt. This is because there capital structure is already not optimal i.e. they are using less debt & more equity which is keeping their WACC high. Retiring debt & issuing more equity will further increase the WACC for the firm thus they should not do that.

Part 5.

The current prime rate is 4.75% (as on 25th November 2019). If the company can borrow at prime+2% , which happens to be 6.75%, the cost of capital will be the same as calculated above (Assuming that the capital structure remains the same) as the firm's cost of debt was already 6.75%

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