Question

Suppose the ABC company has a D/E ratio of 0.6. The risk-free rate is 3% and the market risk premium is 8%. Calculate the firm’s WACC assuming a 30% tax rate, a cost of debt of 5% and an unleveraged beta of the industry (asset beta) of 1.5 (use the Hamada formula).

A. 8,44%

B. 6,88%

C. 11,45%

D. 13,84%

Answer 1

Solution:
	Answer is D. 13.84%
Working Notes:
	First of all we will get beta of equity using Hamada formula and then we use that in CAPM formula to get cost of equity and at last we will get WACC.
	We use Hamada formula to get beta of equity by inserting beta of assets
	B assets = Beta equity/[1+ (debt/equity) x (1-tax rate)]
	1.5 = Beta equity /[(1+ (0.60) x (1-30%)]
	1.5 = Beta equity /1.42
	Beta equity = 1.5 x 1.42
	Beta equity =2.13
	Now we calculate of cost of capital using CAPM
	K= rf + (rm-rf) x beta of assets
	rf= risk free rate = 3%
	market risk premium = rm -rf = 8%
	beta of equity = Be=2.13
	Ke= cost of equity = ??
	Ke= rf + (rm-rf) x Be
	Ke= 3%+ 8% x 2.13
	Ke= 20.04%
At last	Weighted average cost of capital (WACC)
	WACC = (E/V) x Ke + (D/V) (1 -Tax rate) Kd
	debt equity ratio = 0.60
	Weight of Debt = (D/V)=debt equity ratio /(1+ debt equity ratio) =0.60/ (1 +0.60) =0.375
	Weight of Equity =(E/V)= 1/(1+ debt equity ratio) =1 / (1 +0.60) =0.625
	Ke= cost of equity = 20.04%
	cost of debt Kd = 5%
	Tax rate = 30%
	WACC = (E/V) x Ke + (D/V) (1 -Tax rate) Kd
	WACC = (0.625) x 20.04% + (0.375) x 5% x ( 1 -30%)
	WACC = 0.138375
	WACC=13.8375%
	WACC=13.84%
Please feel free to ask if anything about above solution in comment section of the question.