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.

What is the proportion of debt and equity?

What is the CAPM?

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

Answer:

Value of Equity = $120,000,000
Value of Debt = $80,000,000
Value of Firm = $120,000,000 + $80,000,000
Value of Firm = $200,000,000

Proportion of Debt = 80,000,000 / 200,000,000
Proportion of Debt = 0.40

Proportion of Equity = 120,000,000 / 200,000,000
Proportion of Equity = 0.60

As per CAPM, Cost of Equity = Risk Free Rate + Beta * (Market Return - Risk Free Rate)
Cost of Equity = 0.08 + 1.50 * (0.14 – 0.08)
Cost of Equity = 0.08 + 0.09
Cost of Equity = 0.17 or 17%

Cost of Debt = 12%
After Tax Cost of Debt = 0.12 * (1 – 0.35)
After Tax Cost of Debt = 0.078 or 7.80%

WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of Equity * Cost of Equity)
WACC = (0.40 * 0.078) + (0.60 * 0.17)
WACC = 0.0312 + 0.102
WACC = 0.1332 or 13.32%