Question

The Ex Nihilo Corporation has a debt-equity ratio of 0.5. Details of the balance sheet are given in Table 3.

Table 3: Ex Nihilo Co’s balance sheet (market values, numbers in millions)

	Assets	Liabilities
Fixed Investments	£18,000
Debt		?
Equity		?

The beta of Ex Nihilo Co’s fixed investments is 1.5. The risk-free rate is 3% and the average return on the market index is 7%.

What is the weighted average cost of capital (WACC)?

Answer 1

Answer :

Given

Debt - Equity Ratio = 0.5 : 1

==> Debt = 0.5 Equity

Total of Debt & Equity = Total of Fixed Investment

Therefore,

Equity + Debt = 18,000

Replacing Debt as 0.5 Equity

Equity + 0.5 Equity = 18000

1.5 Equity = 18000

==> Equity = 18000 / 1.5

= 12,000

Debt = 0.5 * Equity

= 0.5 * 12000

= 6000

Weight of Debt = 6000 / (12000 + 6000)

= 0.33333333

Weight of Equity = 12000 / (12000 + 6000)

= 0.66666667

Cost of Equity = Risk free rate + Beta * ( Return from Market - Risk free rate)

= 3% + 1.5 * (7% - 3%)

= 3 % + 1.5 * (4%)

= 9%

Cost of Debt = 3.5%

WACC=(Cost of equity *Weight of Equity)+ (Cost of Debt *Weight of Debt)

= (9% * 0.66666667 ) + (3.5% * 0.33333333)

= 7.167%