Acetate, Inc., has equity with a market value of $22.2 million and debt with a m

Question

Acetate, Inc., has equity with a market value of $22.2 million and debt with a market value of $6.66 million. Treasury bills that mature in one year yield 5 percent per year, and the expected return on the market portfolio is 12 percent. The beta of Acetate’s equity is 1.07. The firm pays no taxes.

What is the firm’s weighted average cost of capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

What is the cost of capital for an otherwise identical all-equity firm? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  Cost of capital

I cannot figure out cost of capital but the other two are correct-thanks!

Acetate, Inc., has equity with a market value of $22.2 million and debt with a market value of $6.66 million. Treasury bills that mature in one year yield 5 percent per year, and the expected return on the market portfolio is 12 percent. The beta of Acetate’s equity is 1.07. The firm pays no taxes.

Explanation / Answer

Levered beta = 1.07

Debt equity ratio = 3

Tax rate = 0%

Unlevered beta is calculated below using following formula:

Unlevered beta = beta (levered) / 1 + (1 - tax rate) x (Debt/Equity)

                           = 1.07 / [1+ (1 – 0%) × (3 / 1)]

                           = 1.07 / [1+ 3]

                           = 0.2675

Now cost of capital for unlevered firm is calculated below using CAPM model:

Cost of capital = Risk free rate + (Market Return - Risk free rate) × Beta

                      = 5% + (12% - 5%) × 0.2675

                       = 5% + 7% × 0.2675

                       = 5% + 1.87%

                       = 6.87%%

Hence, cost of capital for unlevered firm is 6.87%.

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