18 February 2021 | Activity 3 - Assessing Long-term Debt, Equity and Capital Structure

Name:

Problems 1 through 3 refer to Gweneth Company

Problem 1

Gweneth Company has expected earnings before interest and taxes (EBIT) of P 800,000 and
interest costs of P 80,000. The firm’s equity and debt capitalization rates are 12 percent and 8
percent, respectively. Assume no corporate income taxes.

a. What is the market value of the firm?

b. What is the weighted average cost of capital?

Problem 2

The Gweneth Company sells additional debt and uses the proceeds to purchase its common
stock. The firm’s total interest costs increase to P 200,000 but its EBIT remains constant at P
800,000. The firm’s debt capitalization rate remains at 8 percent but its equity capitalization rate
increased to 12.5 percent. Assume no corporate taxes.
What is the total market value of the firm?

a. What is the total market value of the firm?

b. What is the weighted average cost of capital?
c. Is Gweneth operating in the world hypothesized by the traditionalist or by Modigliani and
Miller?

Problem 3

Assume that Gweneth Company described in Problems 1 and 2 exists in the Modigliani and
Miller world without corporate taxes.

a. What is the total market value of the firm?

b. What is the weighted average cost of capital?
c. What is the cost of equity, given the increase in debt capital described in Problem 2?

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