Question

1. Acrobat Corporation has 40% debt and 60% equity on its balance sheet.

a.) Solve for Acrobat’s cost of debt if it has a 2% probability of default, a Loss Given Default of 55%, the risk-free rate is 2% and a tax rate of 21% (4 points).

b.) Solve for Acrobat’s cost of equity if it has an equity beta of 1.5 and the market risk premium is 5.5% (4 points).

c.) Solve for Acrobat’s weighted average cost of capital (WACC) (4 points)

Answer 1

a)
Cost of debt = (1 + risk free rate) / ((1 - probability of default) + Probability of default * (1 - loss given default)) - 1

= (1 +2%) / ((1 - 0.02) + 0.02 * (1 - 0.55)) - 1

= (1.02 / 0.989) - 1

= 1.0313 - 1

= 3.13%

Cost of debt = 3.13%

After tax cost of debt = 3.13% * (1 - 0.21) = 2.48%

b)

Cost of equity = Risk free rate + beta * market risk premium
= 2% + 1.5 * 5.5%
= 2% + 8.25%
= 10.25%

c)

WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)
= (40% * 2.48%) + (60% * 10.25%)
= 0.9905% + 6.15%
= 7.14%