Question

"You are considering starting a firm. To see whether it s a positive NPV investment, you need to estimate the cost of capital. You have identified three publicly traded firms that operate in the same industry but have different capital structures and estimated the following values. Given the values in the table below, which of the following statements about your startup are correct?"

	βD	βE	β0	RD	RE	R0	WACC
Firm 1	0	1.1	1	6.0%	11.5%	9.0%	8.8%
Firm 2	0.2	1.3	0.9	7.0%	12.5%	8.8%	8.2%
Firm 3	0.3	1.5	1.1	8.0%	13.5%	9.8%	8.0%
Average	0.17	1.3	1	7.0%	12.5%	9.2%	8.3%

	A.	All the averages in the table apply to the startup
	B.	βE = 1.3
	C.	RE = 12.5%
	D.	WACC = 8.3%

Answer 1

Answer-

The correct Option is D. WACC = 8.3%.

Inorder to calculate the positive NPV the cost of capital ie. the WACC will be the average of all publicly traded firms that operate in the same industry but have different capital structures.

The other Options are incorrect.

Option A is incorrect. All the averages will not apply to the startup as it will have different values for Beta of equity and return on equity (RE).

Option B is incorrect as Beta may be different depending on proportion on equity ot it may finance with debt.

Option C is incorrect. The RE = 12.5 %, is incorrect as the return on equity may differ depending on the equity or the company may be completely financed with debt.