Maria Gonzalez, Ganado\'s Chief Financial Officer, estimates the risk-free rate
ID: 2790557 • Letter: M
Question
Maria Gonzalez, Ganado's Chief Financial Officer, estimates the risk-free rate to be 3.00%, the company's credit risk premium is 3.80%, the domestic beta is estimated at 1.14, the international beta is estimated at 0.93, and the company's capital structure is now 55% debt. The expected rate of return on the market portfolio held by a well-diversified domestic investor is 9.8% and the expected return on a larger globally integrated equity market portfolio is 8.80%. The before-tax cost of debt estimated by observing the current yield on Ganado's outstanding bonds combined with bank debt is 7.80% and the company's effective tax rate is 40%. For both the domestic CAPM and ICAPM, calculate the following:
a. Ganado's cost of equity
b. Ganado's after-tax cost of debt
c. Ganado's weighted average cost of capital
Explanation / Answer
Statement showing required answers
Particulars Domestic CAPM International CAPM Ganado's beta, 1.14 0.93 Risk-free rate of interest, krf 3% 3% Company credit risk premium 3.80% 3.80% Cost of debt, before tax, kd 7.80% 7.80% Corporate income tax rate, t 40% 40% General return on market portfolio, km 9.80% 8.80% Optimal capital structure: Proportion of debt, D/V 55% 55% Proportion of equity, E/V 45% 45% a) Ganado's cost of equity ke = krf + ( km - krf ) 10.75% 8.39% b) Ganado's cost of debt, after tax kd x ( 1 - t ) 4.68% 4.68% c) Ganado's weighted average cost of capital WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ] 7.41% 6.35%