Question

Ganado's Cost of Capital.  Maria​ Gonzalez, Ganado's Chief Financial​ Officer, estimates the​ risk-free rate to be 3.60 %, the​ company's credit risk premium is 3.60​%, the domestic beta is estimated at 0.98​, the international beta is estimated at 0.74​, and the​ company's capital structure is now 65​% debt. The expected rate of return on the market portfolio held by a​ well-diversified domestic investor is 9.80​% and the expected return on a larger globally integrated equity market portfolio is 8.80 %. The​ before-tax cost of debt estimated by observing the current yield on​ Ganado's outstanding bonds combined with bank debt is 8.00​% and the​ company's effective tax rate is 39%.

For both the domestic CAPM and​ ICAPM, calculate the​ following:
a.​ Ganado's cost of equity
b.​ Ganado's after-tax cost of debt
c.​ Ganado's weighted average cost of capital

Answer 1

a. Domestic cost of equity :

Rf = 3.6 Rm = 9.8 Beta = 0.98

CAPM /cost of equity or Ke = Rf + Beta (Rm - Rf) = 3.6 + 0.98 (9.8 - 3.6) = 9.676 %

International cost of equity

Rf = 3.6 Rm = 8.8 Beta = 0.74

ICAPM or international cost of equity or IKe = Rf + International Beta (Rm - Rf) = 3.6 + 0.74 (8.8 - 3.6) = 7.448 %

b. Cost of Debt or Kd = The cost of debt * (1 - marginal tax rate) = 8 (1-0.39) = 8 * 0.61 = 4.88 %

In this case both the domestic and international cost of debt is same.

c. Weighted average cost of capital or WACC is found in the following manner:

Cost of equity * Weight of equity + Cost of weight * Weight of debt = Ke * we + Kd * wd

Weight of debt is given as 65 % or 65/100 = 0.65

As only two kind of asset classes are involved, when we have the weight of one asset class, we can find the weight of the other asset class. So weight of equity = 100% - 65% = 35 % = 0.35

weight of equity = 0.35

WACC domestic = 9.676 * 0.35 + 4.88 * 0.65 = 6.5586 %

WACC International = 7.448 * 0.35 + 4.88 *0.65 = 5.7788 %