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Business Finance question: Please help me! I am so desperate!

Hi everybody, I hope you are all well.

I really need help with my business finance module. I am so stuck and the teachers are so lazy they refuse to help and nor do they teach properly. For example, they will set us with questions which are not covered in seminars nor lectures :'(

Anyway, I have a question about calculating after tax cost of equity, after tax cost of debt, and after tax weighted average cost of capital (WACC).
Now in the second year we did this stuff in the absence of tax and it was easy.

This year however there is the introduction of tax and this is where things get complicated because in the question, there is no detail of the risk free rate, beta and market return (if I had these then at least I would know how to calculate after tax cost of equity!) nor any mention of the dividend growth rate in order to use the Gordon model.

So my question is, how would you calculate the after tax cost of equity, debt, and WACC, when all you've been given is the following:
Market value of Equity
Market value of Debt and Interest on Debt
Tax Rate
And Earnings

Please someone help me as I am so stuck and stressed, I feel like shooting myself :'( ;/

Reply 1

MahmoodReza

Deduct tax relief off debt (not equity), calculate cost of equity - and then weight the individual elements using market values. Your course text will have examples

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Reply 2

s93

Hi, and thanks so much for your response!

Okay so I think I've worked it out. Can you tell me if this is correct?

According to Modigliani and Miller, Vg = Vu+ Dt
So for example, if a company has £20m MV of equity, and £20m MV of debt at 5%, with earnings of £8m, and the tax rate is 30%,
then the value of an equivalent ungeared company would be: £40m - (0.3*£20m) = £34m

The cost of equity for the equivalent ungeared company would therefore be: (£8m * 1 - 0.3)/£34m = 16.47 %

The cost of equity for the geared company would therefore be: re = r0+ ((r0 - rd (1-t))D/E
> re = 16.47 + (16.47 - 5 (1-0.3) £20/£20m = 24.5%

Is that correct? I can work out the WACC and everything else after that but I am having difficulty working out the cost of equity.