Smaltz Enterprises is currently involved in its annual review of the firm\'s cos

Question

Smaltz Enterprises is currently involved in its annual review of the firm's cost of capital. Historically, the firm has relied on the CAPM to estimate its cost of equity capital. The firm estimates that its equitybeta is 1.25, and the current yield on long-term U.S. Treasury bonds is 4.28%. The firm's CFO is currently in a debate with one of the firm's advisors at its investment bank about the level of the equity risk premium. Historically, Smaltz has used 7% to approximate the equity risk premium. However, the investment banker argues that this premium has shrunk dramatically in recent years and is more likely to be in the 3% to 4% range.

a. Estimate Smaltz's cost of equity capital using a market risk premium of 3.5%.

b. Smaltz's capital structure is comprised of 75% equity (based on current market prices) and 25% debt on which the firm pays a yield of 5.125% before taxes at 25%.

c. What is the firm's WACC under each of the two assumptions about the market risk premium?

Explanation / Answer

According to CAPM,

Cost of Equity = Risk Free Rate + Beta*Equity Risk Premium

a)

Risk Free Rate = 4.28%

Beta = 1.25

Risk Premium = 3.5%

Cost of Equity = 4.28% + 1.25*3.5% = 8.66%

b) Yield = 5.125%

Taxes = 25%

C)

>>> Assumption that Risk Premium is 3.5%

Cost of Debt = 5.125% * (1-25%) = 3.84%

At 75% Equity and 25% Debt

Weighted Average Cost of Capital (WaCC) = .75*8.66% + .25*3.84% = 7.45%

>>> Assumption that Risk Premium is 7%

Cost of Equity = 4.28% + 1.25*7% = 13.03%

At 75% Equity and 25% Debt

Weighted Average Cost of Capital (WaCC) = .75*13.03% + .25*3.84% = 10.73%

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