Caballos, Inc., has a debt to capital ratio of 39%, a beta of 1.73 and a pre-tax
ID: 2774356 • Letter: C
Question
Caballos, Inc., has a debt to capital ratio of 39%, a beta of 1.73 and a pre-tax cost of debt of 5.4%. The firm had earnings before interest and taxes of $ 799 million for the last fiscal year, after depreciation charges of $ 291 million. The firm had capital expenditures of $ 333 million, and non-cash working capital increased by $ 62 million. The firm also had a book value of capital of $ 2 billion at the beginning of the last fiscal year. (The treasury bond rate is 4.1 %, the market risk premium is 5.6 % 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
We have:
Rf = 3.20%
MRP= 6.60%
Beta = 1.26
Cost of equity = Rf +(MRP xbeta)
= 3.20% +(1.26 x6.60%)
= 11.516%
Cost of debt = before tax cost x (1- tax rate)
Kd = 5.4% x(1-0.40)
=3.24%
Weight of debt Wd = 0.39
Weight of Equity We = 1-0.39 =0.61
Cost of capital = Wd xKd + We x Ke
= 0.39 x3.24% + 0.61x11.516%
=8.29%