Gnomes R Us is considering a new project. The company has a debt-equity ratio of

Question

Gnomes R Us is considering a new project. The company has a debt-equity ratio of .78. The company’s cost of equity is 14.6 percent, and the aftertax cost of debt is 7.9 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +2 percent. Requirement 1: What is the company’s WACC? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) WACC % Requirement 2: What discount rate should the firm use for the project? (Do not round intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Project discount rate %

Explanation / Answer

1)

D/E = 0.78/1

D/A = D/(D+E) = .78/(.78+1) = 0.4382

E/A = 1-D/A = 1 - 0.4382 = 0.56179

WACC = aftertax cost of debt*D/A + cost of equity*E/A

= 7.9*0.4382+14.6*0.56179 = 11.66%

2) Discount rate for the project = WACC + adjustment factor = 11.66+2 = 13.66%

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