Question

​Ganado's Cost of Capital.  Maria​ Gonzalez, Ganado's Chief Financial​ Officer, estimates the​ risk-free rate to be 3.90%​, the​ company's credit risk premium is 3.80​%, the domestic beta is estimated at 0.92​, the international beta is estimated at 0.61​, and the​ company's capital structure is now 80​% debt. The expected rate of return on the market portfolio held by a​ well-diversified domestic investor is 9.00% and the expected return on a larger globally integrated equity market portfolio is 8.20 %. The​ before-tax cost of debt estimated by observing the current yield on​ Ganado's outstanding bonds combined with bank debt is 7.90​% and the​company's effective tax rate is42​%.

For both the domestic CAPM and​ ICAPM, calculate the​ following:

a.​ Ganado's cost of equity

b.​ Ganado's after-tax cost of debt

c.​ Ganado's weighted average cost of capital

Answer 1

We need to employ CAPM (capital asset pricing model) in this case, CAPM helps us to find out cost of equity based on given market.

Cost of Equity, Re = Risk Free Rate + Beta * (Risk Premium)

Risk Premium = Return on Market - Risk Free Rate

Answer to Part A

Gonado's cost of equity for domestic CAPM = Risk Free Rate + Domestic Beta * (Domestic Market return - Risk free rate)

substituting values, Re(domestic) = 3.9% + 0.92 * (9%-3.9%) = 3.9% + 4.69% = 8.59%

Gonado's cost of equity for International CAPM = Risk Free Rate + International Beta * (International Market return - Risk free rate)

substituting values, Re(International) = 3.9% + 0.61 * (8.2%-3.9%) = 3.9% + 2.62% = 6.52%

Answer to Part B

After tax cost of Debt = Cost of Debt * (1 - tax rate)

substituting values, = 7.9% * (1- 42%) = 4.58%

Answer to Part C

Weighted average cost of capital = (weight of debt * after tax cost of debt) + (weight of equity * cost of equity)

substituting values for domestic CAPM

WACC (domestic CAPM) = (0.80 * 4.58%) + (0.20 * 8.59%) = 5.38%

WACC (ICAPM) = (0.80 * 4.58%) + (0.20 * 6.52%) = 4.96%