Adobe Inc’s stock currently has a beta of 0.90. Adobe has a debt-to-equity ratio

Question

Adobe Inc’s stock currently has a beta of 0.90. Adobe has a debt-to-equity ratio of .50. The expected return on the market portfolio is 9%. The risk-free rate is 2%. The company’s current cost of debt is 4 percent. The corporate tax rate is 40%

a. What is current stockholder required return for Adobe?

b. What is Adobe’s weighted average cost of capital (WACC)?

c. Adobe decides to modify its capital structure – it will now be financed entirely with equity (no debt in the capital structure).   What is Adobe’s new stockholder required return (now that it has no debt in the capital structure)? Be sure to provide a numerical answer.

Explanation / Answer

a)Required return = Rf+ Beta(Rm- rF)

                           = 2 + .90 (9 - 2)

                           = 2 + .90 * 7

                           = 2 + 6.3

                            = 8.3%

B)Wd= .5 /(1+.5) = .5/1.5 = .3333

We = 1/1.5 = .6667

WACC =(Afer tax cost of debt *WD) +(Cost of equity *We)

           = [4(1-.40) ] * .3333 +   (8.3 * .6667)

           = 2.4 *.3333   +    8.3*.6667

           = .79992 + 5.53361

           = 6.33% (approx)

c) The new stock holders required return will be equal to WACC= 6.33%

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