Question

Mackenzie Company has a beta of 1.2, the risk-free rate is 3.5%, and it estimates the market risk premium to be 6%. It has a cost of debt of 6%, and is financed 70% with equity and 30% with debt. Mackenzie’s tax rate is 21%. Estimate the equity cost of capital for Mackenzie. What is this firm's WACC?

Answer 1

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

It is calculated using the formula below:

Ke=Rf+b[E(Rm)-Rf]

Where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

b= stock’s beta

Ke= 3.5% + 1.2*6%

     = 3.5% + 7.20% = 10.70%.

Weighted Average Cost of Capital (WACC) is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.30*6%*(1-0.21) + 0.70*10.70%

            = 0.30*4.74% + 0.70*10.70%

            = 1.42% + 7.49% = 8.91%.