Problem 14-21 Cost of Capital Acetate, Inc., has equity with a market value of $
ID: 2793916 • Letter: P
Question
Problem 14-21 Cost of Capital Acetate, Inc., has equity with a market value of $22.1 million and debt with a market value of $8.84 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 1.06. The firm pays no taxes. a. What is Acetate's debt-equity ratio? (Do not round intermediate calculations and round your final answer to 2 decimal places (e.g., 32.16).) Debt-equity ratio 40 b. 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 (o.g., 32.16)) Weighted average cost of capital c. 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 (o.g., 32.16).) Cost of capitalExplanation / Answer
Answer b)
First we calculate the cost of equity
Cost of equity = Risk free rate + Beta * (Market return - Risk free rate)
= 6%+1.06*(11%-6%)
= 11.3%
WACC = Weight of debt * cost of debt + weight of equity * cost of equity
Weight of debt = 8.84 / (8.84 + 22.1) = 28.57%
Weight of equity = 1-0.2857 = 71.43%
WACC = 28.57%*10% + 71.43%*11.3% = 10.93%
Answer c) Cost of capital for firm with all equity will be cost of capital of equity i.e 11.30% (Calculation above)