Question

What is a firm's weighted-average cost of capital if the stock has a beta of 1.1, Treasury bills yield 4%, and the market portfolio offers an expected return of 16%? In addition to equity, the firm finances 70% of its assets with debt that has a yield to maturity of 10%. The firm is in the 35% marginal tax bracket.

Answer 1

Weighted average Cost of capital = (Weight of equity)*(Cost of Equity) + (Weight of Debt)*(Cost of Debt)*(1 - Tax rate)

Cost of Equity can be calculated by using CAPM

Cost of Equity = Risk-Free Rate + Beta (Market Return - Risk-Free Rate)

Treasury Bill is considered riskless, so its return is a risk-free return.

= 4% + 1.1 ( 16% - 4%)

= 17.2%

YTM of the bond is the cost of Debt.

Weighted Average Cost of capital = (0.3)* (17.2%) + (0.7) * (10%) * (1 - 35%)

= 9.71%

So the weighted Average cost of capital is 9.71%

If you find the solution helpful, then please give a rating.