Question

Cost of Capital. Blues, Inc. is an MNC located in the U.S. Blues would like to estimate its weighted average cost of capital (WACC). On average, bonds issued by Blues yield 7 percent. Currently, Treasury security rates are 2 percent. Furthermore, Blues’ stock has a beta of 2, and the return on the Wilshire 5000 stock index is expected to be 8 percent. Blues’ target capital structure is 40 percent debt and 60 percent equity. If Blues is in the 30 percent tax bracket, what is its weighted average cost of capital?

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Slater Co. is a U.S.-based MNC that finances all operations with debt and equity. It borrows U.S. funds at an interest rate of 6 percent per year. The long-term risk-free rate in the U.S. is 3 percent. The stock market return in the U.S. is expected to be 10 percent annually. Slater’s beta is 1.5. Its target capital structure is 30 percent debt and 70 percent equity. Slater Co. is subject to a 30% corporate tax rate. Estimate the cost of capital to Slater Co.

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Answer 1

a)	Cost of debt		=	Yeild*(1-taxrate)
			=	7%*(1-0.3)
			=	7%*0.7
			=	4.90%
	As per CAPM(Capital asset pricing model)
	Cost of equity		=	Risk free rate+ (market rate-Risk free rate)*beta
			=	2% +(8%-2%)*2
			=	2%+ 6%*2
			=	2%+12%
			=	14.00%
	Weighted average cost of capital				=	Wight of debt*cost of debt +weight of equity*cost of equity
					=	0.4*4.9% +0.6*14%
					=	1.96% + 8.4%
					=	0.1036
					=	or 10.36%
b)	Cost of debt		=	Interest*(1-taxrate)
			=	6%*(1-0.3)
			=	6%*0.7
			=	4.20%
	As per CAPM(Capital asset pricing model)
	Cost of equity		=	Risk free rate+ (market rate-Risk free rate)*beta
			=	3% +(10%-3%)*1.5
			=	3%+ 7%*1.5
			=	3%+10.5%
			=	13.50%
	Weighted average cost of capital				=	Wight of debt*cost of debt +weight of equity*cost of equity
					=	0.3*4.2% +0.7*13.5%
					=	1.26% + 9.45%
					=	0.1071
					=	or 10.71%
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