Question

Maria​ Gonzalez, Ganado's Chief Financial​ Officer, estimates the​ risk-free rate to be 3.60​%, the​ company's credit risk premium is 4.20​%, the domestic beta is estimated at 1.19​, the international beta is estimated at 1.03​, and the​ company's capital structure is now 40​% debt. The expected rate of return on the market portfolio held by a​ well-diversified domestic investor is 9.70​% and the expected return on a larger globally integrated equity market portfolio is 8.50​%. The​ before-tax cost of debt estimated by observing the current yield on​ Ganado's outstanding bonds combined with bank debt is 7.70​% and the​ company's effective tax rate is 35​%. 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

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3.6 + 1.19 * (9.7 - 3.6)

Expected return% = 10.86

international

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 3.6 + 1.03 * (8.5 - 3.6)

Expected return% = 8.65

b.

for both domestic & international

after tax cost of debt = (risk free rate+credit risk premium)*(1-tax rate) = (3.6+4.2)*(1-0.35)=5.07

c.

domestic

Weight of equity = 1-D/A

Weight of equity = 1-0.4

W(E)=0.6

Weight of debt = D/A

Weight of debt = 0.4

W(D)=0.4

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.68*0.4+10.86*0.6

WACC% = 8.39

international

Weight of equity = 1-D/A

Weight of equity = 1-0.4

W(E)=0.6

Weight of debt = D/A

Weight of debt = 0.4

W(D)=0.4

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.68*0.4+8.65*0.6

WACC% = 7.06