Question

A semiconductor company has an equity beta of 1.8, a debt-to-equity ratio of 0.05, an average cost of debt of 6.0% p.a., and an effective income tax rate of 12%. The current rate on long-term U.S. government Treasury Bills is 2.2% p.a. The market risk premium (R M -R F ) pertaining to a diversified portfolio of corporate common stock is about 8.4% p.a. Estimate this company’s cost of equity and its weighted average cost of capital. If the company were to increase its debt-to equity ratio from 0.05 to 0.20, what would be its cost of equity and weighted average cost of capital (assuming the increased leverage does not affect the company’s average cost of debt)? Meanwhile, an electric utility company has an equity beta of 0.84, a debt-to-equity ratio of 0.46, an average cost of debt of 4.3% p.a., and an effective income tax rate of 30%. What is the utility company’s cost of equity and weighted average cost of capital? Also, explain why there are differences between these two companies with respect to their beta values, debt-to-equity ratios, and average cost of debt.

Answer 1

a) Semiconductor company: Using CAPM, Cost of equity, re = Rf + beta x (Rm - Rf) = 2.2% + 1.8 x 8.4% = 17.32%

WACC = we x re + wd x rd x (1 - tax)

we - weight of equity = 1 / (D/E + 1) = 1 / 1.05 = 95.24%, re - cost of equity = 17.32%, wd = 1 - we = 4.76%, rd - cost of debt = 6%, tax = 12%

=> WACC = 95.24% x 17.32% + 4.76% x 6% x (1 - 12%) = 16.75%

If D/E = 20% => we = 83.33% and wd = 16.67%

=> WACC = 15.31%

b) Electric Utility company: Using CAPM, Cost of equity, re = Rf + beta x (Rm - Rf) = 2.2% + 0.84 x 8.4% = 9.256%

WACC = we x re + wd x rd x (1 - tax)

we - weight of equity = 1 / (D/E + 1) = 1 / 1.46 = 68.49%, re - cost of equity = 9.256%, wd = 1 - we = 31.51%, rd - cost of debt = 4.3%, tax = 30%

=> WACC = 68.49% x 9.256% + 31.51% x 6% x (1 - 30%) = 8.00%