Question

A company has a debt-to-equity ratio of 1/4 in terms of market values. Its equity beta is 1.15 and its cost of debt is 3.5%. Its tax rate is expected to be 20%. Assume the risk-free rate of 3% and the market risk premium of 7%. What is its weighted average cost of capital (WACC)?

Answer 1

First we need to calculate the cost of equity.
Cost of equity=Risk free rate + Beta*(Market risk premium)
Given that, the risk free rate is 3%, beta is 1.15 and market risk premium is 7%. Using these values in the equation, we get
Cost of equity=3%+1.15*(7%)=0.03+0.0805=0.1105 or 11.05%

Given that debt/equity=1/4
Adding the denominator to numerator on both the sides, we get
=>(debt+equity)/equity=(1+4)/4=5/4
Inverting both the sides, we get
equity/(debt+equity)=4/5
=>Weight of equity=4/5

Again, debt/equity=1/4
Inverting both the sides, we get
equity/debt=4=4/1
Adding denominator to numerator on both the sides, we get
(equity+debt)/debt=(4+1)/1=5/1
Inverting both the sides, we get
debt/(equity+debt)=1/5
=>Weight of debt=1/5

Weighted average cost of capital (WACC)=Weight of equity*Cost of equity+Weight of debt*Cost of debt*(1-Tax rate)

Weight of equity=4/5
Cost of equity=0.1105
Weight of debt=1/5
Cost of debt=3.5%
Tax rate=20%
WACC=4/5*0.1105+1/5*3.5%*(1-20%)
=0.0884+1/5*3.5%*(0.8)
=0.0884+0.0056
=0.094 or 9.40%