Question

Using the following information, calculate the Weighted Average Cost of Capital (Ka) for the Carmel Restaurant:

Capital Structure is 40% debt/ 60% equity, Interest Rate (Kdbt) = 7.5%, tax rate = 30%, market portfolio (Km) = 10.5%, risk-free rate = 4%, beta is estimated at 0.9 and the company has enough in new retained earnings to finance the equity portion of the capital budget.

Answer 1

Solution:

Calculation of cost of equity :

Cost of equity as per Capital Asset Pricing Model is calculated using the following formula :

Ke = Rf + [ β * ( Km – Rf ) ]

Where

Ke = Cost of equity    ; Rf = Risk free rate   ; β = Beta ; RM = Return on market portfolio ;

As per the information given in the question we have

Rf = 4 %   ; Km = Return on market portfolio = 10.5 % ;   β = 0.9   ;

Applying the above values in the formula we have cost of equity as

= 4 % + [ 0.9 * ( 10.5 % - 4 % ) ]

= 4 % + [ 0.9 * 6.5 % ]

= 4 % + 5.85 % = 9.85 %

Thus the cost of equity = 9.85 %   

Calculation of Weighted Average Cost of Capital ( WACC ) :

The formula for calculating the weighted average cost of capital is =

WACC = Ka = [ Ke * We ] + [ ( Kdbt * ( 1 - t ) ) * Wdbt ]

Ke = Cost of equity ; We = Weight of equity ; Kdbt = Cost of debt    ; t = Income tax rate ; Wdbt  = Weight of debt

As per the information available in the question we have

Ke = 9.85 % = 0.0985   ; We = 60 % = 0.60 ;   Kdbt = 7.5 % = 0.075 ; t = 30 % = 0.30   ; Wdbt = 40 % = 0.40 ;

Applying the above values in the formula we have

= [ 0.0985 * 0.60 ] + [ (0.075 * ( 1 – 0.30 ) ) * 0.40 ]

= [ 0.0985 * 0.60 ] + [ (0.075 * 0.70 * 0.40 ]

= [ 0.05910 + 0.02100   ]

= 0.08010

= 8.01 %   

Thus the WACC of Carmel Restaurant is = 8.01 %