Question

Pribolof Seal Works is financed one quarter with debt and three quarters with equity. Pribolof’s bonds have a beta of .25 while the stock beta is 1.30. The U.S. Treasury bond is yielding 4% and the market risk premium is 6%. Pribolof faces a tax rate of 35%. What is Pribolof’s weighted average cost of capital?

Answer 1

Proportion of Debt Financing = D = One Quarter or 0.25, Proportion of Equity Financing = E = Three Quarters or 0.75,

US Treasury Bond Yield = Risk-Free Rate = Rf = 4 % and Market Risk Premium = Rm = 6 %

Debt Beta = Bd = 0.25 and Stock Beta = Bs = 1.3

Using CAPM Cost of Equity = ke = Rf + Bs x Rm = 4 + 1.3 x 6 = 11.8 %

Using CAPM, Cost of Debt = kd = Rf + Bd x Rm = 4 + 0.25 x 6 = 5.5 %

Tax Rate = t = 35 %

Weighted Average Cost of Capital = D x (1-t) x kd + E x ke = 0.25 x (1-0.35) x 5.5 + 0.75 x 11.8 = 9.74375 % ~ 9.74 %