Spam Corp. is financed entirely by common stock and has a beta of 1.0. The firm
ID: 2805836 • Letter: S
Question
Spam Corp. is financed entirely by common stock and has a beta of 1.0. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price-earnings ratio of 8 and a cost of equity of 12.5%. The company's stock is selling for S50. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with a 5% interest rate. The company is exempt from corporate income taxes. Assuming MM are correct, calculate the following items after the refinancing a. b. The cost of equity The overall cost of capital (WACC)Explanation / Answer
Cost of Equity = 1/Price Earnings Ratio
=1/8
=0.125 or 12.50%
Calculation of WACC
WACC =8.75%
Source Proportion % WACC Equity 0.50 12.50% 6.25%(12.50*0.50) Debt 0.50 5% 2.50% WACC 8.75%