Question

The current market rate of return is 12% and the risk-free rate is 4%. You have been given the job of determining your firm's cost of capital components. The company has 1 million shares outstanding with a current value of $22.50 per share. The debt represents 30% of the capital structure and the yield to maturity is 12%. The beta of the equity is 1.4 and the tax rate is 30%. a. What is the market value of firm and the debt respectively? b. What is the required rate of return on equity? c. What is the firm's WACC?

Answer 1

Shares O/s=	1,000,000.00
Current value	22.5
Equity capital	22,500,000.00	(22.5*1000000)
Equity as a % of capital structure=	70%	(Since debt is 30%)
So total capital =	32142857.14	22500000/70%
debt=	9,642,857.14	(32142857.14-22500000)
So market value of firm is	$ 32,142,857.14
debt=	$   9,642,857.14

As per CAPM
Required rate of return= Rf + (Rm-Rf)*Beta
Rf=Risk free interest	Rf=4%	Rm=12%	Beta=1.40
Rm=market return
Required rate of return(%)=	4+(12-4)*1.4
	15.2

After tax cost of debt=	8.4	(12*70%)
Computation of WACC
		Market Value
Particulars	Cost	Weights	Amount
Equity	15.2%	0.70	22,500,000.00
debt	8.40%	0.30	9,642,857.14
		1	32,142,857.14
WACC(%)		13.16
		(0.70*15.2)+(0.30*8.40)
WACC= weight of equity *cost of equity+weight of debt*cost of debt