Estimating Components of both WACC and DDM Analysts estimate the cost of debt ca
ID: 2658415 • Letter: E
Question
Estimating Components of both WACC and DDM
Analysts estimate the cost of debt capital for Abbott Laboratories (NYSE: ABT) is 2.13% and that its cost of equity capital is 4.1%. Assume that ABT's marginal tax rate is 36%, the risk-free rate is 5.3%, the market risk premium is 5.7%, the ABT market price is $47.73 per common share, and its dividends are $1.26 per common share.
(a) Compute ABT's average borrowing rate and its market beta. (Round your answers to one decimal place.)
Average borrowing rate = Answer%
Market beta = Answer
(b) Assume that its dividends continue at the current level in perpetuity. Use the constant perpetuity dividend discount model to infer the market's expected cost of equity capital. (Hint: Use Price per share = Dividends per share/Cost of equity capital.) (Round your answer to one decimal place.)
Answer%
(c) Compare the inferred cost of equity capital from part (b) to the 4.1% estimated cost of equity capital from analysts.
The inferred cost of equity capital seems high compared to 4.1%, which suggests that the investment has a negative beta.
The inferred cost of equity capital seems low compared to 4.1%, which suggests that the investment has a negative beta.
The inferred cost of equity capital seems high compared to 4.1%, which suggests that the investment has a positive beta.
The inferred cost of equity capital seems low compared to 4.1%, which suggests that the investment has a positive beta.
Explanation / Answer
(a) Cost of Debt Capital = 2.13 %, Tax Rate = 36 %, Cost of Equity Capital = 4.1 %, Risk-Free Rate = 5.3 %, Market Risk Pemium = 5.7 %, Market Price = $ 47.73, Dividends Per Share = $ 1.26
As the interest paid on long-term debt is tax deductible, the cost of debt capital is usually expressed on an after-tax basis and hence is different from the interest rate/average borrowing rate.
Average Borrowing Rate = Cost of Debt Capital / (1-tax rate) = 2.13 / (1-0.36) = 3.328 %
Let the market beta be B
Therefore, 4.1 = 5.3 + B x 5.7
- 1.2 = B x 5.7
B = - 0.21
(b) Market price = $ 47.73, Dividend = $ 1.26 and let the cost of equity be K
Therefore, 47.73 = 1.26 / K
K = 0.0264 or 2.64 % approximately.
(c) The inferred cost of capital is lower as compared to 4.1% which implies that the investment is not as risky as the analysts' would like to believe. Hence, the investment might have returns that move in a direction opposite to that of the broader market, thereby implying a negative beta.
Hence, the correct option is statement 2.
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