Question

At December 31,2017, Day-Brite Inc.’s market value of equity was $8 billion and its total market value was $12 billion. Day-Brite’s assumed statutory tax rate was 32%, its pretax borrowing rate was 4%, and its estimated market beta was .78. Assume also that the expected risk-free rate is 2.5% and the expected market risk premium is 5%. Estimate Day-Brite’s weighted average cost of capital.

4.2%

5.2%

3.9%

2.5%

Answer 1

Compute the after tax cost of debt, using the equation as shown below:

Cost of debt = Rate of borrowings*(1 – Tax rate)

                    = 4%*(1 – 0.32)

                    = 2.72%

Hence, the after-tax cost of debt is 2.72%.

Compute the cost of equity, using the equation as shown below:

Cost of equity = Risk free rate + (Beta*Market risk premium)

                        = 2.5% + (0.78*5%)

                        = 2.5% + 3.9%

                        = 6.4%

Hence, the cost of equity is 6.4%.

Compute the market value of debt, using the equation as shown below:

Market value = Total market value – Market value of equity

                      = $12 billion - $8 billion

                      = $4 billion

Hence, the market value of debt is $4 billion.

Compute the weighted average cost of capital (WACC), using the equation as shown below:

WACC = (Debt capital*Cost of debt/ Total market value) + (Equity capital*Cost of equity/ Total market value)

             = ($4 billion*2.72%/ $12 billion) + ($8 billion*6.4%/ $12 billion)

             = 0.907% + 4.267

             = 5.174%

Hence, the WACC is 5.2%.