Question

Joe Bob Coffee is one of the Pacific Northwest's many fine publicly traded coffee companies. Joe Bob Coffee's required return on equity is 14.0%, its weighted average cost of capital is 11.3, and the beta on its debt is zero. Joe Bob Coffee is expected to generate a dividend of $2 per share next year and future dividends are expected to grow at 5% per year forever after. There are 1 million shares outstanding. Assume that the expected return on the market is 11%, the risk-free rate is 5%, and the company does not pay corporate taxes. a. What fraction of Joe Bob Coffee's capital structure is currently equity? b. If Joe Bob Coffee decides to replace all of the debt in its capital structure with equity, what will its required return on equity become?

Answer 1

a).

Let Weight of equity =x
Weight of Debt =1-x
if beta=0
Cost of debt =Risk free rate =5%
WACC =Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt=x*14%+(1-x)*5%=11.3%
9%x=11.3%-5%
Fraction of equity x =6.3%/9% =70% or 0.7

b).

If all debt is required with equity the cost of equity will be WACC =11.3%