Question

1) Fama's Llamas has a weighted average cost of capital of 13 percent. The company's cost of equity is 18 percent, and its pretax cost of debt is 7.5 percent. The tax rate is 31 percent. What is the company's target debt-equity ratio?

• 0.9091

• 0.6709

• 0.607

• 0.639

• 0.6645

2) Stock in Daenerys Industries has a beta of 1.14. The market risk premium is 8.5 percent, and T-bills are currently yielding 4.5 percent. The company's most recent dividend was $1.7 per share, and dividends are expected to grow at a 7 percent annual rate indefinitely. If the stock sells for $35 per share, what is your best estimate of the company's cost of equity? 10.83% 13.19% 9.06% 14.19% 12.2%

Answer 1

Question 1:

Given :

WACC = 13%

Cost of Equity (Ke) = 18%

Pre-tax cost of Debt (Kd) = 7.5%

Tax Rate = 31%

Therefore,

WACC = Weight of Equity * (Ke) + Weight of Debt * (Kd) * (1-tax rate)

Let the weight of Equity be 'x'; then weight of debt b '1-x' :

13 = (x*18) + [(1-x)*{7.5*(1-0.31)}]

13 = 18x + [(1-x)*5.175]

13 = 18x + 5.175-5.175x

13-5.175 = 12.825x

It implies,

12.825x = 7.825

x = 7.825/12.825

x = 0.61

• Weight of Equity = 0.61
• Weight of Debt (1-0.61) = 0.39
• Debt Equity Ratio = 0.39/0.61 = 0.639

Question 2:

Note : According to the data given in the question we can find out the cost of equity by two methods-

1) CAPM Model

2) Dividend Discount Model

A. Calculation of Cost of Equity using CAPM :

Given :

Beta of the stocks in the industry = 1.14

Market risk premium (Rm-Rf) = 8.5%

T-bills yield i.e., risk free rate (Rf) = 4.5%

Cost of Equity (Ke) = Rf + Beta * (Rm-Rf)

Ke = 4.5 + 1.14 * (8.5)

Ke = 14.19%

B. Calculation of Cost of Equity (Ke) using Dividend Discount Model :

GIven :

Dividend (D0) = $1.7

Growth rate (g) = 7% or 0.07

Current Stock Price (P0) = $35

• P0 = [D0 * (1+g)]/Ke-g

35 = [1.7*(1+0.07)]/Ke-0.07

35 * (Ke-0.07) = 1.819

35Ke - 2.45 = 1.819

Ke = (1.819+2.45)/35

Ke = 0.12197 i.e., 12.2%