Question

The following financial statement data pertains to Southwater, Inc., a manufacturer of women's suits (dollar amounts in millions):

Total Assets	$154,287
Interest-Bearing Debt	$33,984
Average Pre-tax borrowing cost	7.75%
Common Equity:
Book Value	$21,365
Market Value	$66,735
Income Tax Rate	39.60%
Market Equity Beta	0.77
Market Premium	7.45%
Risk-free interest rate	2.50%

Required:

a.	Calculate the company's cost of equity capital.
b.	Calculate the weight on debt capital that should be used to determine Southwater's, weighted-average cost of capital.
c.	Calculate the weight on equity capital that should be used to determine Southwater's weighted-average cost of capital.
d.	Calculate Southwater's weighted-average cost of capital.

Be sure to show your work in a neat and professional manner.

Answer 1

a) We can use CAPM to arrive at Cost of Equity.

Cost of Equity (Ke) = Risk Free Rate + Beta (Market Risk Premium)

= 2.5% + 0.77(7.45%) = 8.24%

b) Before we find the weight lets arive at the cost of debt.

Cost of Debt (Kd) = Average Pre-Tax Borrowing Cost (1 - Tax Rate)

= 7.75% (1-0.396) = 7.75% * 0.604 = 4.68%

Arriving at Cost of Debt using Market Value of Equity -

Total Cost = Debt + MV of Equity = 33,984 + 66,735 = $100,719

Weight of Debt Capital (W1) = Debt / Total Cost = 33,984/100,719 = 0.3374

c) Weight of Equity Capital (W2) = MV of Equity / Total Cost (or) 1 - Weight of Debt Capital

= 66,735/100,719 = 0.6626

d) Weight Average Cost of Capital (WACC) = (Ke * W2) + (Kd * W1)

= 8.24% * 0.6626 + 4.68% * 0.3374 = 5.46% + 1.58% = 7.04%