Equity investors have contributed $250,000 to your start-up business, while creditors provided a loan of $300,000. You have calculated your firm's WACC at 10 percent. The annual interest payment is $25,000 and the marginal corporate tax rate is 21 percent. How much profit will your equityholders need to earn in order to break even in economic terms (i.e., EVA of zero)?

Question

Quizplus · Accepted Answer

First, we need to calculate the total cost of capital:
Total cost of capital = (Equity / Total Investment) * Cost of Equity + (Debt / Total Investment) * Cost of Debt * (1 - Tax Rate)
Total Investment = $550,000
Equity = $250,000
Debt = $300,000
Cost of Equity = WACC = 10%
Cost of Debt = (Annual interest payment / Debt) = $25,000 / $300,000 = 8.33%
Tax Rate = 21%
Total cost of capital = (250,000 / 550,000) * 10% + (300,000 / 550,000) * 8.33% * (1 - 21%) = 8.74%
Now we can calculate the economic profit that equityholders need to earn:
Economic profit = (Equity * Return on Equity) - (Total Investment * Total cost of capital)
Since we want EVA of zero, we set economic profit to zero and solve for Return on Equity:
0 = (250,000 * Return on Equity) - (550,000 * 8.74%)
Return on Equity = $35,250
Therefore, the equityholders need to earn a profit of $35,250 to break even in economic terms.

Equity Investors Have Contributed $250,000 to Your Start-Up Business, While