Acetate, Inc., has equity with a market value of $22.7 million and debt with a m
ID: 2757613 • Letter: A
Question
Acetate, Inc., has equity with a market value of $22.7 million and debt with a market value of $9.08 million. Treasury bills that mature in one year yield 6 percent per year, and the expected return on the market portfolio is 11 percent. The beta of the company’s equity is 1.12. The company pays no taxes.
What is the company’s weighted average cost of capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
What is the cost of capital for an otherwise identical all-equity company? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
a. What is the company's debt–equity ratio? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Explanation / Answer
Answer-
A. Debt-equity ratio is $9.08M/$22.7M = 0.4
When we get to a weighted-average cost-of-capital, we?ll use slightly
different numbers. Equity to total valuation (E/VL) is $22.7M/$31.78M or
71.42% and debt to total valuation is $9.08M/$31.78M or 28.57%.
B. WACC
Rc = rf + ßc(rM - rf)
=0.06+1.12(0.11-0.06) =11.6%
Where,
Rc is the company's expected return on capital
rf is the risk-free return rate, usually a long-term U.S. Treasury bill rate
rM is the expected return on the entire market of all investments.
ßc is the company's Beta, based on its covariance with the market.
Now on to the WACC --
WEIGHTED-AVERAGE COST OF CAPITAL
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The full weighted-average cost-of-capital (WACC) for a firm is given by:
WACC = Rc (E/VL) + rD(1-t)(D/VL)
where,
Rc: return on equity
E/VL: proportion of equity in total firm value
rD: debt or bond percentages
D/VL: proportion of debt in total firm value(
There are no taxes here, so WACC simplifies to:
WACC = Rc (E/VL) + rD (D/VL)
WACC = .116 (.7142) + 0.06 (..2857) = 9.99%
C. ALL EQUITY FIRM
We?ve actually figured out the cost-of-capital already for an all
equity firm ? Rc = 11.6% Except in extreme cases, the level of
leverage makes no difference in the cost of equity.