Question

What is a firm's weighted-average cost of capital if the stock has a beta of 1.45, Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In addition to equity, the firm finances 30% of its assets with debt that has a yield to maturity of 9%. The firm is in the 35% marginal tax bracket.

Answer 1

Solution :

Calculation of cost of equity :

Cost of equity is calculated using the following formula :

R_E = R_F + [ β * ( R_M - R_F ) ]

Where

R_E = Cost of equity    ; R_F = Risk free rate of return   ; β = Beta of the stock ;

R_M = Expected return on market portfolio ;

As per the information given in the question we have

R_F = Yield on a Treasury bill = Risk free rate of return = 5 %   ;

R_M = 14 %   ;   β = 1.45   ;

Applying the above values in the formula we have

= 5 % + [ 1.45 * ( 14 % - 5 % ) ]

= 5 % + [ 1.45 * 9 % ]

= 5 % + 13.05 %

= 18.05 %

Thus the cost of equity = 18.05 %

Calculation of WACC :

The formula for calculating the weighted average cost of capital is =

WACC = [ K_e * W_e ] + [ ( K_d * ( 1 - t ) ) * W_d ]

K_e = Cost of equity ; W_e = Weight of equity ; K_d = Pre tax Cost of debt    ;

t = Income tax rate ; W_d = Weight of debt ;

As per the information available in the question we have

K_e = 18.05 % = 0.1805   ; W_e = ( 100 % - weight of debt ) = ( 100 % - 30 % ) = 70 % = 0.70 ;

K_d = 9 % = 0.09 ; t = 35 % = 0.35   ; W_d = 30 % = 0.30 ;

Applying the above values in the formula we have

= [ 0.1805 * 0.70 ] + [ ( 0.09 * ( 1 – 0.35 ) ) * 0.30 ]

= [ 0.1805 * 0.70 ] + [ 0.09 * 0.65 * 0.30 ]

= [ 0.126350 + 0.017550 ]

= 0.143900

= 14.39 %   

Thus the WACC of the firm is = 14.39 %       

= 14.4 % ( when rounded off to one decimal place )