Question

Beta firm has a capital structure containing 60% debt and 40% ordinary stock equity. Its outstanding bonds offer investors as 6.5% yield to maturity. The risk-free rate currently equals 5%, and the expected risk premium on the market portfolio equals 6%. The firm's common stock beta is 1.20.

a) What is the firm's required return on equity?

b)Ignoring taxes, use your finding in part (a) to calculate the firm's WACC.

c)Assuming a 40% tax rate, recaluculate the firm's WACC found in part (b).

d)Compare and contrast the values for the firm's WACC found in parts (b) and (c).

Answer 1

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

B / C / D E Risk free rate Market risk premium Equity beta Cost of equity 5% 6% 1.2 12.20% a) Cost of Debt (before tax) 6.50% 9 b) 10 Capital Structure Capital Debt Equity Weight 60% 40% Cost 6.50% 12.20% Firm's WACC 8.78% 11 12 13 14 15 16 17 c) 18 19 20 Tax rate 40% Capital Structure Capital Weight Debt 60% After tax Cost 3.90% 12.20% Equity 40% Firm's WACC 7.22% With tax rate of 40%, Firm's WACC reduced by 1.56%

Cell reference -

ДА B Risk free rate Market risk premium Equity beta 5 a) Cost of equity 0.05 0.06 1.2 =C2+C4*C3 7 Cost of Debt (before tax) 0.065 8 Capital Weight 0.6 Cost =C7 =C5 0.4 =SUMPRODUCT(C11:C12,D11:D12) 9 b) Capital Structure 10 11 Debt 12 Equity 13 Firm's WACC 15 16 17 c) Tax rate 18 19 Capital Structure 20 21 Debt Equity 0.4 Capital Weight 0.6 0.4 After tax Cost =C7*(1-C17) =C5 Firm's WACC =SUMPRODUCT(C21:C22,D21:D22) | d) With tax rate of 40%, Firm's WACC reduced by =C14-C24

Hope it will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.