Bay of lands Diaries has an interest cost of debt of 6 percent per annum. The sy
ID: 2667518 • Letter: B
Question
Bay of lands Diaries has an interest cost of debt of 6 percent per annum. The systematic risk of its equity is 1.2, and the effective tax rate is 0.12. forty percet of its funding is provided by debt, while 60 percent is proviided by equity. The risk free interest rate is 5 percent per annum. In calculating its cost of capital, Bay of Islands has obtained two expert opinions as to the market risk premium ( including the franking premium). One expert suggests that the market risk premium is 1 percent per annum, while the other suggests that the market risk premium is 5 percent per annum. What is Bay of Islands cost of capital based on expert's opinion on market risk premium. ?Explanation / Answer
Cost of Debt = 6% per annum
Systematic risk of its equity = 1.2
Effective tax rate = 0.12
Debt financing = 40%
Equity financing = 60%
Risk-free interest rate = 5%
One expert suggests that the market risk premium is 1% per annum:
Weighted Average Cost of Capital Calculation (WACC):
WACC = (E/V) * RE + (D/V) * RD (1-Tc)
(E/V) = 0.60
(D/V) = 0.40
Cost of Common Equity (According to CAPM):
Cost of Common Equity (RE) = Rf + (MRP)
Cost of Common Equity (RE) = 0.05 + 1.2 (0.01)
Cost of Common Equity (RE) = 0.05 + 0.012
Cost of Common Equity (RE) = 0.062 (or) 6.2%
WACC = [0.60 * 0.062 + {0.40 * 0.06 (1-0.12)}]
WACC = [0.0372 + {0.40 * 0.0528}]
WACC = [0.0372 + 0.02112]
WACC = 0.05832 (or) 5.83%
WACC = 5.83%
Bay of Islands Cost of Capital based on expert’s opinion on market risk premium = 5.83%
Other expert suggests that the market risk premium is 5% per annum:
Weighted Average Cost of Capital Calculation (WACC):
WACC = (E/V) * RE + (D/V) * RD (1-Tc)
(E/V) = 0.60
(D/V) = 0.40
Cost of Common Equity (According to CAPM):
Cost of Common Equity (RE) = Rf + (MRP)
Cost of Common Equity (RE) = 0.05 + 1.2 (0.05)
Cost of Common Equity (RE) = 0.05 + 0.06
Cost of Common Equity (RE) = 0.11 (or) 11%
WACC = [0.60 * 0.11 + {0.40 * 0.06 (1-0.12)}]
WACC = [0.0372 + {0.40 * 0.0528}]
WACC = [0.066 + 0.02112]
WACC = 0.08712 (or) 8.71%
WACC = 8.71%
Bay of Islands Cost of Capital based on expert’s opinion on market risk premium = 8.71%
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