Question

Calculate the following:

The cost of equity if the risk-free rate is 2%, the market risk premium is 8%, and the beta for the company is 1.3.

The cost of equity if the company paid a dividend of $2 last year and is expected to grow at a constant rate of 7%. The stock price is currently $40.

The weighted average cost of capital (WACC) if the company has a total value of $1 million with a market value of its debt at $600,000 and a market value of its equity at $400,000. Its cost of debt is 6% and its cost of equity is 15%. The tax rate it pays is 25%.

Answer 1

Answer a.

Risk-free Rate = 2%
Beta = 1.30
Market Risk Premium = 8%

Cost of Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Equity = 2% + 1.3 * 8%
Cost of Equity = 12.40%

Answer b.

Last Year Dividend, D0 = $2
Growth Rate, g = 7%
Stock Price, P0 = $40

Cost of Equity = D0*(1 + g) / P0 + g
Cost of Equity = $2*1.07 / $40 + 0.07
Cost of Equity = 12.35%

Answer c.

Weight of Debt = Value of Debt / Value of Firm
Weight of Debt = $600,000 / $1,000,000
Weight of Debt = 60%

Weight of Equity = Value of Equity / Value of Firm
Weight of Equity = $400,000 / $1,000,000
Weight of Equity = 40%

WACC = Weight of Debt * Cost of Debt * (1 - tax) + Weight of Equity * Cost of Equity
WACC = 60% * 6% * (1 - 0.25) + 40% * 15%
WACC = 8.70%