Question

3. The total market value of the common stock of the Company A is $7 million, and the total value of its debt is $3 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the market risk premium is 6%. The Treasury bill rate is 4%. Assume for simplicity that Company A debt is risk-free. The Company’s tax rate is 35%. What is after tax WACC for Company A?

Answer 1

Cost of Equity, by CAPM Method = R_f + (B * R_p)

R_f is the Risk Free Rate = 4%

B (Beta) = 1.5

R_p is the Market Risk Premium = 6%

=> Cost of Equity = 4% + (1.5 * 6%) = 13%

Cost of Debt(pretax), in this question, is 4% (since it is to be assumed risk free)

Post Tax Cost of Debt = Pretax cost of debt * (1 - tax rate) = 4% * (1 - 35%) = 2.60%

In order to calculate WACC, we need to calculate weighted average of post tax cost of debt and cost of equity.

WACC = Amount of capital = Amount of debt + Amount of Equity = $10 mil (in this question)

WACC = (7/10)*(13%) + (3/10)*(2.6%) = 9.88%