Question

1. Votoan has the following capital components and costs.

Component                 Value               After-tax Cost
Debt                            15,500             11%
Preferred Stock           7,500               14%
Common Equity         10,000             16%

What is Votoan’s weighted average cost of capital?

A. 11.67%

B.12.41%

C.13.19%

D.14.55%

2. Poss Inc. (PI) common stock has a beta of 1.3. If the expected return on the average stock is 16 percent and the risk-free rate is 6 percent, what is the required rate of return for PI?

A.12.2%

B.16.4%

C.19.0%

D.13.2%

Answer 1

What is Votoan’s weighted average cost of capital?

Answer: C) 13.19%

What is the required rate of return for PI?

Answer: C) 19%

Working:

Calculation of weighted average cost of capital

Formula for calculating WACC = Kd * Wd + Ke * We + Kp * Wp

Where,

Kd = after tax cost of debt

Wd = Weight of Debt

Ke = Cost of Common Equity

We = Weight of Common Equity

Kp = Cost of Preferred Stock

Wp = Weight of Preferred Stock

Details available from the problem are

Kd = after tax cost of debt =	11%
Ke = Cost of Common Equity =	16%
Kp = Cost of Preferred Stock =	14%

Since Weight of Debt, Common Equity and Preferred stock are not available we need to find those

Calculation of weights:

Component	Working	Weight
Debt	= (Value of Debt ÷ Total Value) *100 = (15,500 ÷ 33,00)*100 = 46.97%	46.97%
Common Equity	= (Value of Common Equity ÷ Total Value) *100 = (10,000 ÷ 33,00)*100 = 30.30%	30.30%
Preferred Stock	= (Value of Preferred stock ÷ Total Value) *100 = (7500 ÷ 33,00)*100 =22.73%	22.73

Total Value     = value of Debt + Value of Common Equity + Value of Preferred stock

                        =15,500 + 10,000 + 7500

                        = 33,000

WACC            = Kd * Wd + Ke * We + Kp * Wp

                        = 11% * 46.97% + 16% * 30.30% + 14% * 22.73%

                        = 5.1667% + 4.848% + 3.1822

                        = 13.1969

                        =13.19%

The required rate of return for PI

Formula for calculating required rate return as per capital asset pricing model is as follows,

Required rate return = R_f + β (Rm - R_f)

Where,

R_{f =} Risk free rate of return = 6%

β = Beta = 1.3

Rm = Market rate return (expected return on the average stock) = 16%

Required rate of return                    = 6% + 1.3(16% - 6%)

                                                            = 6% +13%

                                                            = 19%