(a) Calculate each of the following: 1.The firm’s cost of equity 2.The portion o

Question

(a) Calculate each of the following:

1.The firm’s cost of equity

2.The portion of the cost of equity attributable to the firm’s operating risk.

3.The portion of the cost of equity attributable to the firm’s financial risk.

(1) You are preparing a valuation for Acrobatics Corp. Based on the firm's most recent statement, the firm has debt of $1,000 and free cash flow of $2,250. The firm is stable and the constant, nominal growth rate is 7%. The firm's current stock price is $3 with 1,000 shares outstanding. Additionally, the firm has an equity beta of 1.2 and a cost of debt of 10%. Assume that the expected return on the market is 14%, the risk free rate is 5%, and the tax rate is 30%. Carry all percentages to 2 decimal places, for example, 70, 11.25% is not rounded to 11%

Explanation / Answer

1)Cost of equity using capm model

=risk free+beta*(market return-risk free)

=5%+(1.2*(14%-5%))

=15.8%

beta unlevered= beta levered/(1+(D/e)*(1-tax))

beta levered=1.2

D=1000

E=1000*3=3000

Tax=30%

Beta unlevered=0.973

Cost of capital= 5%+(0.973*(14%-5%))

=13.76% and this is cost of equity for operating risk

cost of equity for financial risk= 15.8%-13.76%=2.04%

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