Question

The debt/equity ratio is 1.2. The value of your company (debt + equity) is $6,000,000. Your company wants to use CAPM to calculate the cost of equity. Beta is 1.23. The market risk premium is 7% and the market return is 10%. Your debt is trading at par value and has a coupon rate of 4%. Relevant tax rate is 21%. What is your company’s WACC?

Multiple Choice

• 5.31%

• 9.47%

• 10.42%

• 7%

• 8.12%

Answer 1

D/A = D/(E+D)

D/A = 1.2/(1+1.2)

=0.5455

Weight of equity = 1-D/A

Weight of equity = 1-0.5455

W(E)=0.4545

Weight of debt = D/A

Weight of debt = 0.5455

W(D)=0.5455

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 3 + 1.23 * (7)

Cost of equity% = 11.61

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 4*(1-0.21)

= 3.16

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=3.16*0.5455+11.61*0.4545

WACC =7%