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A company is financed by a mixture of equity and debt capital, whose market values are in the ratio 3:1. The debt capital, which is considered risk-free, yields 10% before tax. The average stock market return on equity capital is 16%. The beta value of the company’s equity capital is estimated as 0.95. The tax rate is 30%.
What would be an appropriate cost of capital to be used for investment appraisal of new projects with the same systematic risk characteristics as the company’s current investment portfolio?
a 7.0%
b 10%
c 13.5%
d 15.7%Answer – C
Could you help me with this problem? The company is financed by both equity and debt capital and the given estimations are combined. Do we need to split up? I tried with this formula Re = D1/P0 + g but, didn’t work. Please help me with it.
Thanks a lot,
The cost of equity is determined by the beta factor and so is equal to 10 + 0.95 (16 – 10) = 15.7%.
The cost of debt (after tax, as always) is 10 ( 1 – 0.3) = 7%So the WACC is (3/4 x 15.7%) + (1/4 x 7%) = 13.5%
I do suggest that you watch my free lectures (especially on CAPM) – they are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well).
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