Caballos, Inc., has a debt to capital ratio of 46%, a beta of 1.91 and a pre-tax
ID: 2734908 • Letter: C
Question
Caballos, Inc., has a debt to capital ratio of 46%, a beta of 1.91 and a pre-tax cost of debt of 5.1%. The firm had earnings before interest and taxes of $ 674 million for the last fiscal year, after depreciation charges of $ 291 million. The firm had capital expenditures of $ 329 million, and non-cash working capital increased by $ 56 million. The firm also had a book value of capital of $ 1.2 billion at the beginning of the last fiscal year. (The treasury bond rate is 4.8 %, the market risk premium is 5.3 % and the firm has a tax rate of 40 %). Assume that the firm is in stable growth, and that the return on capital and reinvestment rates for the last fiscal year can be sustained forever. Estimate the Cost of Capital.
Explanation / Answer
Debt to capital ratio = 46%
Weight of debt = 46%
Weight of equity = 54%
Pretax cost of debt = 5.1%
Tax rate = 40%
After tax cost of debt = 5.1% × (1 – 40%)
= 3.06%
After tax cost of debt = 3.06%
Risk free rate = 4.8%
Risk Premium = 5.3%
Beta = 1.91
Cost of equity is calculated below using CAPM formula:
Cost of equity = Risk free rate + Risk Premium × Beta
= 4.8% + 5.3% × 1.91
= 4.8% + 10.12%
= 14.92%
Cost of equity is 14.92%.
Now WACC is calculated below:
WACC = 54% × 14.92% + 46% × 3.06%
= 8.06% + 1.41%
= 9.47%
Hence, WACC of company is 9.47%.
So, cost of capital of company is WACC of the company which is 9.47%.