Question

10. What is the cost of equity capital for PCP based on the CAPM (Capital Asset Pricing Model)? Use the information in footnote 15.
    "FOOTNOTE 15: BERKSHIRE HATHAWAY's cost of equity was 9.2%, which reflected a beta of .90, an expected market return of 9.90%, and a risk-free rate of 2.89%. The yield on corporate bonds rated AA was 3.95% - and after a 39% expected marginal tax rate, the cost of debt would be 2.3% Weights on capital were 16.9% for debt and 83.1% for equity. In contrast, the beta for PCP was .38. Analysts expected that PCPs cash flows would grow indefinitely at about the long-term expected real growth rate of the US Economy, 2.5%"
    
    A. 5.55% B. 6.65% C. 9.20% D. 11.80%

11. What is the Weighted Average Cost of Capita that should be used by BRK to value PCP based on the cost of debt (AA rating), tax rate, and capital structure that are given in footnote 15. Use the cost of equity based on CAPM (see Q10). You must get Q10 correct before answering this question.
    A. 5.0%
    B. 5.5%
    C. 8.0%
    D. 9.2%

Answer 1

1.Calculation of Cost of Equity of PCP as per CAPM

Cost of Equity=Risk-free rate + Beta *( Expected Market Return - Risk-free rate)

Given ,Risk-free rate=2.89%

Expected market Return=9.90%

Beta =.38

Cost of Equity= 2.89 + .38 (9.90 -2.89)

=5.5538% or 5.55%

Therefore Option A 5.55% is correct.

2. Calculation of WACC of PCP

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

Given that Cost of Debt ,tax rate and capital structure in footnote 15

WACC=5.55* .831 + 2.3* .169

WACC=5.0%

Therefore Option A is correct.