Question

1. What are two different ways to estimate the cost of equity for a firm?

2. Lewis runs an outdoor adventure company and wants to know what effect a tax change will have on his company’s WACC. Currently Lewis has the following financing pattern:

            Equity: 35% and cost of 14%

            Preferred stock: 15% and cost of 11%

            Debt: 50% and cost of 10% before taxes

      What is the WACC for Lewis if the tax rate is
a. 30%?

      b. 40%?

Answer 1

(1)-The two different ways to estimate the cost of equity for a firm

The two method to estimate the cost of equity for a firm is using the Capital Asset Pricing Model (CAPM) Approach and Dividend Growth Model

As per CAPM Approach, the Cost of Equity is calculated as follows

Cost of Equity (Ke) = Risk-free Rate + Beta(Market Return – Risk-free Rate)

As per Dividend Growth Model, the Cost of Equity is calculated as follows

Cost of Equity (Ke) = [D1 / P0] + g

Where, “D1” is the Dividend per share in next year

“P0” is the Current Market Price per share

“g” is the Dividends Growth Rate

(2)(a)-Weighted Average Cost of Capital (WACC) for Lewis if the tax rate is 30%

Weighted Average Cost of Capital (WACC) = [Cost of Equity x Weight of Equity] + [Cost of Preferred Stock x Weight of Preferred Stock] + [After-Tax Cost of Debt x Weight of Debt]

= [14% x 0.35] + [11% x 0.15] + [10%(1 – 0.30) x 0.50]

= 4.90% + 1.65% + 3.50%

= 10.05%

(2)(b)-Weighted Average Cost of Capital (WACC) for Lewis if the tax rate is 40%

Weighted Average Cost of Capital (WACC) = [Cost of Equity x Weight of Equity] + [Cost of Preferred Stock x Weight of Preferred Stock] + [After-Tax Cost of Debt x Weight of Debt]

= [14% x 0.35] + [11% x 0.15] + [10%(1 – 0.40) x 0.50]

= 4.90% + 1.65% + 3%

= 9.55%