Case Problem 5

Touring Enterprises, Inc., has a capital structure consisting of $18 million in long-term debt and $7 million in common equity. There is no preferred stock outstanding.

The interest rate paid on the long-term debt is 10%. The firm is in the 35% tax bracket.

On the common equity (stock), the Company pays an annual dividend of $1.20 and expects to increase the dividend by 5% per year. The market price of the stock is $50.

Based on this information, answer the following questions:

Calculate Touring Enterprises' weighted average cost of capital (WACC).

Work as follows: first, compute the after-tax cost of debt, then compute the cost of equity. Cite both formulas, and show all your work.

Determine the weightings of debt and equity in the capital structure.

Using your answers to the above questions, calculate the WACC.

2. If Touring Enterprises were to increase the percentage of debt in its capital structure, what would happen to the WACC ? No calculation is necessary- simply provide a short, non-numeric response.

3. Identify and explain the benefits and risks of debt financing. A two-paragraph answer will suffice.

Hints

Think of the WACC as follows: (weighting of debt * after-tax cost of debt) + (weighting of equity * cost of equity).
Also, compute the costs of debt and equity in percentage terms from the very beginning. If you use decimals, you will have to deal with multiplying many decimals which can lead to confusion.