Acetate, Inc., has equity with a market value of $23.7 million and debt with a m
ID: 2781399 • Letter: A
Question
Acetate, Inc., has equity with a market value of $23.7 million and debt with a market value of $9.48 million. The cost of debt is 10 percent per year. 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 Acetate’s equity is 1.22. The firm pays no taxes.
What is the firm’s weighted average cost of capital? (Do not round intermediate calculations. 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 firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places (e.g., 32.16).)
Acetate, Inc., has equity with a market value of $23.7 million and debt with a market value of $9.48 million. The cost of debt is 10 percent per year. 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 Acetate’s equity is 1.22. The firm pays no taxes.
Explanation / Answer
Answer a)
Debt / equity ratio = Market value of debt / Market Value of equity = 9.48/23.7 = 0.4
Answer b)
WACC = weight of debt * cost of debt *(1-tax rate) + weight of equity * cost of equity
First we will calculate the cost of equity
Cost of equity = rf + (rm-rf)*Beta
rf = risk free rate
rm = market return
= 0.06 + (0.11-.06)*1.22
= 0.121
or 12.1%
Cost of equity = 12.1%
Weight of debt = 0.4 /(1+0.4) = 0.285714
Weight of equity = 1-0.285714 = 0.714286
WACC = 0.285714*0.10+0.714286*0.121 =0.115 OR 11.50%
Answer c) According to MM Proposition 2 with no taxes
RE = RUL + [D/E] [RUL – RD]
0.121 = RUL + 0.4 * (RUL - 0.10)
0.121 = RUL +0.4 RUL - 0.040
0.161 = 1.4 RUL
RUL = 0.115 or 11.5%
This result is consistent with MM’s proposition that, in the absence of taxes, the cost of capital for an all-equity firm is equal to the weighted average cost of capital for an otherwise identical levered firm.