Question

You are tasked with estimating the cost of capital for a firm. The risk-free rate is 4%, the expected rate of return on the market is 15.8%. Now, another similar company (similar unlevered cost of capital) has a debt-to-equity ratio of 1 to 3. It has a debt beta near zero and an equity market-beta of 1.5. Your own firm has more debt, for a debt-to-equity ratio of 1 to 1, with a debt beta of 0.1. What is a good estimate for your firm's cost of capital (WACC)?

Answer 1

Firstly, calculate the unlevered beta():

Similar company Debt to equity ratio = 1/3

and, Equity market beta() = 1.5

*tax rate not provided thus we will ignore it.

For given Firm,

Debt to equity ratio = 1/1 = 1

Levered Beta (Equity Beta) of Firm:

Risk free rate (rf) = 4%

Market rate of return (rm) = 15.8%

Equity cost of capital (ke) :

Cost of Debt (kd):

Weight of Equity(We) = 0.5

Weight of Debt (Wd) = 0.5

Thus,