Question

Suppose that your company is launching a new project. To estimate the cost of capital for the project | |||

you search the market and find a company that has very similar risk characteristics to the project as follows: | |||

Market capitalization, MVE = | $100.00 | million | |

Market value of debt, D = | $50.00 | million | |

Cost of debt, Rd = | 5.00% | ||

Cost of equity, Re = | 15.50% | ||

Corporate tax rate, t = | 30% | ||

Calculate the cost of capital of the project for the following two cases: | |||

The project is equity financed. | |||

The project is funded by both debt and equity and has the same leverage ratio (D/E) as does the comparable. |

Answer #1

a.

cost of capital of the project if the project is equity financed is cost of equity that is 15.50%.

b.

The project is funded by both debt and equity and has the same leverage ratio then cost of capital of project would be WACC of company.

Market value of equity = $100 million

Market value of debt = $50 million

Total Value of capital = $150 million.

Weight of debt = 33.33%

Weight of equity = 66.67%

WACC is calculated below:

WACC = (66.67% × 15.50%) + (33.33% × 5%) × (1 - 30%)

= 10.33% + 1.17%

= 11.50%

WACC is 11.50%.

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