By NEAS - 7/22/2022 3:43:15 PM
Corporate finance module 8: Weighted average cost of capital formula
The risk-free rate is 8.97% per annum, the market risk premium is 6.59%, and the tax rate is 27%.
● A firm’s equity has a CAPM β of 0.99
● The firm’s debt yields 11.06% per annum.
● The firm’s debt-to-value ratio is 0.436
A. What is the firm’s cost of equity capital?
B. What is the value of the firm’s debt tax shield (as a percent of the firm’s value)?
C. What is the firm’s after-tax weighted average cost of capital (WACC)?
Part A: The cost of equity capital is the risk-free rate + CAPM β × the market risk premium =
8.97% per annum + 0.99 × 6.59% per annum = 15.49% per annum
Part B: The value of the firm’s debt tax shield is the market value of the debt × the cost of debt capital × the corporate tax rate.
As a percent of the firm’s value, this is the debt to value ratio × the cost of debt capital × the corporate tax rate
= 0.436 × 11.06% per annum × 27% = 1.30%
Part C: WACC = rD (1 – Tc) (D/V) + rE (E/V) or
Weighted average cost of capital = return on debt capital
× (1 – corporate tax rate)
× debt to value ratio
+ return on equity capital
× equity to value ratio
= 11.06% × (1 – 27%) × 0.436 + 15.49% × (1 – 0.436) = 12.26%
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