Question

A firm you have been asked to analyze has $250 million in market
value of debt outstanding and $750 million in equity outstanding.
The debt has a Beta of 0.1 and equity has a Beta of 1.2. Assume the
risk-free rate is 1% and the market *premium* is 7%. Assume
the coupon on the debt is equal to its yield. Also assume the firm
faces a 21% marginal tax rate. Which of the following describes the
firm's WACC?

Answer #1

Cost of debt = Risk free rate + Beta of Debt*(Market premium)

= 1+0.1*(7)

= 1.7%

Cost of equity = Risk free rate + Equity Beta*(Market premium)

= 1+1.2*(7)

=9.4%

WACC = Cost of Debt*(1-tax rate)*(Market value of Debt/(Market value of Debt+Market value of Equity)) + Cost of Equity*(Market value of Equity/(Market value of Debt+Market value of Equity))

= 1.7*(1-0.21)*($250million/($250million+$750million)) + 9.4*($750million/($250million+$750million))

= 1.343*0.25 +9.4*0.75

= 7.39

Therefore, WACC of the firm is 7.39%

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