Question

Bradshaw Steel has a capital structure with 30% debt (all long-term bonds) and 70% common equity. The yield to maturity on the company’s long-term bonds is 8%, and the firm estimates that its overall composite WACC is 10%. The risk-free rate of interest is 5.5%, the market risk premium is 5%, and the company’s tax rate is 40%. Bradshaw uses the CAPM to determine its cost of equity. What is the beta on Bradshaw’s stock? and what is the interpretation for that beta?

Answer 1

Yield on bonds is 8%

Tax rate is 40%

After tax cost of debt = 8(1-0.4) = 4.8%

Weight of debt is 30% and weight of equity is 70%

Wacc is 10%

Let cost of equity is x

10=(30×4.8 + 70×x)/100

1000 = 144 +70x

856=70x

X = 12.23%

According to capm approach expected return on equity is equal to risk free rate plus beta times market risk premium

Risk free rate = 5.5%

Market risk premium = 5%

Let beta = x

12.23 = 5.5 + x(5)

X = 1.346

Beta is the measure of volatility higher beta means that investors assume higher risk with the stock