Question

Hatter, Inc., has equity with a market value of $23.1 million
and debt with a market value of $9.24 million. The cost of debt is
10 percent per year. Treasury bills that mature in one year yield 6
percent per year, and the expected return on the market portfolio
over the next year is 11 percent. The beta of the company’s equity
is 1.16. The firm pays no taxes.

**a.** What is the company’s debt−equity ratio?
**(Do not round intermediate calculations and round your
answer to 2 decimal places, e.g., 32.16.)**

Debt–equity ratio

**
b.** What is the company's weighted average cost of capital?

Weighted average cost of capital %

c.

Cost of capital %

Answer #1

a. The company's debt-equity ratio = $ 9.24 million / $ 23.1 million = 0.40

b. Weighted Average Cost of Capital : 11.29 %

Cost of Equity = 0.06 + 1.16 ( 0.11 - 0.06) = 0.118

Cost of Debt = 0.10

Source of Capital | MV | Weights | Specific Cost of Capital | Weighted Cost of Capital |

Equity | 23.1 | 0.71429 | 0.118 | 0.08429 |

Debt | 9.24 | 0.28571 | 0.10 | 0.02857 |

32.34 | 1.00000 | 0.11286 |

c. Cost of capital for an otherwise identical all equity firm : 11.29%

As per Modigliani-Miller proposition, in the absence of taxes, the cost of capital of an all equity company is the same as the weighted average cost of a levered company.

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