Question

The market value of Owl Fund Industries common stock is $125 million and the market value of its debt is $25 million. The beta of the company's common stock is 1.0 and the expected risk premium on the market portfolio is 6.5 percent. If the Treasury bill rate is 3 percent and the yield on its debt is 4%, what is the company's cost of capital assuming the tax rate is 0%.

Answer 1

Company's cost of capital is the weighted average cost of debt and equity.

First we will calculate the cost of equity by CAPM model by the following formula:

Cost of equity = Risk free rate + Beta * Market risk premium

Given: Risk free rate = Treasury bill rate = 3%, Beta = 1 and Market risk premium = 6.5%

Now, putting these values in the above formula, we get,

Cost of equity = 3 + (1. * 6.5)

Cost of equity = 3 + 6.5 = 9.5%

Now, we will calculate the weighted average cost of capital (WACC). The formula for weighted average cost of capital is:

WACC = E / V * r_e +   D / V * r_d * (1 - t)

where, E = Market value of equity = $125m

D = Market value of debt = $25m

r_e = Cost of equity = 9.5%

r_d = Cost of debt = 4%

V = E + D = $125m + $25m = $150

t = tax rate = 0%

Now, putting these values in the WACC formula, we get,

WACC = (($125 / $150) * 9.5%) + (($25 / $150) * 4% * (1 - 0%))

WACC = 7.92 + 0.67

WACC = 8.58%

So, Cost of capital is 8.58%