Blue Ram Brewing Company currently has no debt in its capital structure, but it
ID: 2792852 • Letter: B
Question
Blue Ram Brewing Company currently has no debt in its capital structure, but it is considering using some debt and reducing its outstanding equity The firm's unlevered beta is 1.1, and its cost of equity is 10.70%. Because the firm has no debt in its capital structure, its weighted average cost of capital (WACC) also equals 10.70%. The risk-free rate of interest (Rr) is 3%, and the market risk premium (RP) is 7%. Blue Ram's marginal tax rate is 35% Blue Ram is examining how different levels of debt will affect its costs of debt and equity, as well as its WACC. The firm has collected the financial information that follows to analyze its weighted average cost of capital (WACC). Complete the following table D/A E/A Ratio Ratio D/E RatioRating Before-Tax Cost of Debt (rd) Bond Cost of Equity (rs) 10.70% 11 .96% 14.06% Levered Beta (b) WACC 10.70% 10.66% 0.0 0.2 0.4 0.6 0.8 1.0 0.8 0.6 0.4 0.2 0.00 0.25 0.67 1.50 8.4% 8.9% 1.58 2.17 3.96 11.61% 14.3% 30.72%Explanation / Answer
WACC=D/A*before tax cost of debt*(1-tax rate)+E/A*cost of equity
D/E=(D/A)/(E/A)
Cost of equity=risk free+beta*market risk premium
Hence,
D/A=0.2: cost of equity=11.96%
Hence,levered beta=(11.96%-3%)/7%=1.28
D/A=0.4: WACC=0.4*8.9%*(1-35%)+0.6*14.06%=10.75%
D/A=0.6: Cost of equity=3%+2.17*7%=18.19%
D/A=0.8: D/E=0.8/0.2=4
WACC=0.8*14.3%*(1-35%)+0.2*30.72%=13.58%