Question

The Bonnie Situation Int'l Inc. currently has 60 percent debt in its capital structure, the corporate tax rate is 0.35 and the before tax cost of debt, r_d, is the same as the risk‑free rate. Given the following market parameters,

              r_m = 9% , r_f =3.75% , ß_L = 1.07

Find the cost of equity, the weighted average cost of capital, the operating risk, i.e., ß_u , the cost of equity if The Bonnie Situation Int'l Inc. were unlevered.

Please show work

Answer 1

Cost of equity = Risk free rate + Beta* (Market return - Risk Free Rate) = 3.75% + 1.07*(9%-3.75%) = 9.37%

WACC = Weight of Debt * Cost of Debt*(1-Tax Rate)+ Weight of Equity * Cost if Equity = 60%*3.75%*(1-0.35)+40%*9.37% =5.21%

Cost of Unlevered Beta = Beta Levered/(1+(1-Tax Rate)*Debt/Equity) = 1.07/(1+(1-0.35)*60%/40%) = 0.5418

Cost of equity(operational Risk) = Risk free rate + Beta* (Market return - Risk Free Rate) = 3.75% + 0.5418*(9%-3.75%) = 6.59%