Answer to Question #171175 in Finance for sai

Question

A) A firm has issued three bonds at different points of time with total values of Rs.5 crore,

Rs.10 crore, and Rs.10 crore with different coupon rates of 8%, 10% and 12% respectively. It

calculated the average cost of debt as 10.4% (shown below) and used it in the computation of

WACC. Was the firm right in using such a method? Comment.

[(5÷25)*8%]+[(10÷25)*10%]+[(10÷25)*12%] = 10.4%

b) A financial analyst opined that a firm must never borrow because borrowing can never be

beneficial to shareholders. Fixed charges of intertest would deplete the cashflows to

shareholders, and thus, they would always be poorer, when compared to shareholders of

unlevered firm, by the amount of interest paid. Do you agree with the statement? Explain

your contentions.

Answer 1

A. The working is correct because, weighted average cost of capital is expressing the various components as a percentage of the total value.

B. Borrowing is healthy to any firm. This is because leverage increases investors returns and interest expense from loan is tax deductible. Loans are also a form of readily available source of capital. Since they enhance operations, returns to shareholders will increase.