Question

The common stock of CORPORATION X has a beta of 0.9. The Treasury bill rate is 4%, and the market risk premium is estimated at 8%. CORPORATION X capital structure is 27% debt, paying an interest rate of 6%, and 73% equity. The debt sells at par. CORPORATION X pays tax at 40%.

1. What is BCCI’s cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.
2. What is its WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Solution :

a. Calculation of Cost of Equity Capital :

Cost of equity as per Capital Asset Pricing Model is calculated using the following formula :

R_E = R_F + β ( R_M - R_F )

Where

R_E = Cost of equity    ; R_F = Risk free rate of return   ; β = Beta of the stock ; ( R_M – R_F ) = Market risk Premium

As per the information given in the question we have

R_F = Treasury Bill rate = 4 %   ; ( R_M - R_F ) = Market Risk Premium = 8 %   ; β = 0.9

Applying the above values in the formula we have

= 4 % + ( 0.9 * 8 % )

= 4 % + 7.20 %

= 11.2 % ( when rounded off to one decimal place )

Thus the cost of equity = 11.2 % .

b. Calculation of WACC :

The formula for calculating the weighted average cost of capital is =

WACC = [ K_e * W_e ] + [ ( K_d ( 1- t ) ) * W_d ]

K_e = Cost of equity ; W_e = Weight of equity ; K_d = Cost of debt    ; t = Income tax rate ; W_d = Weight of debt

As per the information available in the question we have

K_e = 11.2 %    ; W_e = 73 % = 0.73   ;   K_d = 6 % ; t = 40 % = 0.40   ; W_d =27 % = 0.27

Applying the above values in the formula we have

= [ 11.2 % * 0.73 ] + [ ( 6 % * ( 1 – 0.40 ) ) * 0.27 ]

= [11.2 % * 0.73 ] + [ ( 6 % * 0.60 * 0.27 ]

= [ 8.1760 % + 0.9720 % ]

= 9.1480 %

= 9.15 %   ( when rounded off to two decimal places)

Thus the WACC is = 9.15 %.