Question

Marley's Plumbing Shops has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. Its cost of debt financing is 12 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt.

1. What is the proportion of debt and equity?
2. What is the CAPM?
3. What is the after-tax weighted average cost of capital for Marley's, if it is subject to a 35 percent marginal tax rate?

Answer 1

1.Equity= $120,000,000

Debt= $80,000,000

Total firm capital= $120,000,000 + $80,000,000

                                 = $200,000,000.

Proportion of equity in the firm capital structure= $120,000,000/ $200,000,000

                                                                                            = 0.60*100

                                                                                            = 60%

Proportion of debt in the firm capital structure= $80,000,000/ $200,000,000

                                                                                           = 0.40*100

                                                                                           = 40%

2. Cost of equity is the required rate of return on the company’s common stock. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

The formula for calculating the capital asset pricing model is given below:

Ke=Rf+b[E(Rm)-Rf]

Where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

B= Beta of the company

Ke= 8% + 1.58(14% - 8%)

     = 8% + 9.48%

     = 17.48%.

3. WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.40*12%*(1 – 0.35) + 0.60*17.48%

            = 3.12% + 10.49%

            = 13.61%.

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