Answer:
The answer is creating wealth, with the economic value added is $390,000
Explanation:
The company WACC is: Percentage of mortgage bond in capital employed x Cost of mortgage bond x ( 1 - tax rate) + Percentage of unsecured bond in capital employed x Cost of unsecured bond x ( 1 - tax rate) + Percentage of common stock in capital employed x cost of common stock
In which: Percentage of mortgage bond in capital employed = 1,000,000/10,000,000 = 10%
Percentage of unsecured bond in capital employed = 3,000,000/10,000,000 = 30%;
Percentage of common stock in capital employed = (10,000,000 - 1,000,000 - 3,000,000) /10,000,000 = 60%
Cost of common stock = Risk free rate + Risk premium = 10% + 5% = 15%;
Tax rate = 40%
Thus, WACC = 10% x 8% x ( 1- 40%) + 30% x 9% x (1-40%) + 60% x 15% = 11.10%.
Thus, Capital cost per year: Capital employed x WACC = 10,000,000 x 11.10% = $1,110,000.
Economic value added = Operating Income - Capital cost = 1,500,000 - 1,110,000 = $390,000.
