Question

A firm is 85% equity. T-Bills are expected to return 2%. The effective tax rate is 8%. It has 65% of its debt in bonds denominated in euros and 35% in US dollar. The euro debt has a euro YTM of 5.5%; the US dollar debt has a YTM of 6.5%. The 1-year LIBOR rate in euros is 3.5%; in USD is 4.5%. The firm’s global beta 1.10. Assume a global risk premium of 6%.

1. What is the cost of equity?

2. What is the cost of debt of the firm overall?

3. What is the WACC?

Answer 1

(1) COST OF EQUITY

The cost of equity can be calculated using CAPM(capital asset pricing model) which states that

Re= Rf + MRP*beta

Where Re = required rate of return on equity

Rf = Risk free rate

MRP= market risk premium

So we have Rf which is T-bill return at 2%

MRP=6%

BETA=1.10

THUS;

Re= 2 + (6* 1.10)

= 8.6%

COST OF EQUITY IS 8.6%

(2) COST OF DEBT

Cost of debt is [Kd * (1 - t) ] ;

where Kd= cost of debt and t= tax rate

here 65% bonds are denominated in euro and 35% is USD

so Kd= (0.65*5.5) + (0.35* 6.5)

=3.575 + 2.275

= 5.85%

so after tax cost of debt = 5.85 * (1- 0.08)

= 5.3820

AFTER TAX COST OF DEBT IS 5.3820%.

(3)WEIGHTED AVERAGE COST OF CAPITAL (WACC)

  WACC=(We*Ke) + ( Wd * Kd)

here We and Wd are weights of equity and debt respectively.

its given that 85% of firm is funded with equity

so We=85% and Wd=15%

Therefore, WACC= (0.85 * 8.6) + (0.15 * 5.3820)

=7.31 + 0.8073

= 8.1173

THE WEIGHTED AVERAGE COST OF CAPITAL IS 8.1173%.