Question

SMU, Inc. has equity with a market value of $20 million and debt with a market value of $10 million. SMUpays 8% interest on its debt per year, and the expected return on the market portfolio over the next year is 18%. The beta of SMU’s equity is .90. The firm pays no taxes.

a. What is SMU’s debt to equity ratio? What is SMU’s weighted average cost of capital?

b. What is the cost of capital for an otherwise identical all-equity firm?

Answer 1

a. Debt Equity Ratio = Market Value of Debt/ Market Value of Equity

= $10 million / $20 million

= 0.5

Cost of equity = Risk free rate + Beta * ( Expected return - Risk free return)

= 8% + 0.9 * ( 18% -8%)

=17%

WACC = Cost of Debt * Weight of Debt + Cost of equity * Weight of Equity

= 8% * (10/30) + 17% * (20/30)

=14%

b. Cost of equity = Cost of capital for all equity firm + (Debt/ Equity) * (Cost of capital for all equity firm - Risk free rate)

17% = Cost of capital for all equity firm + (0.5) * (Cost of capital for all equity firm - 8%)

Cost of equity = 14%