1
FIN300 Introduction to Managerial Finance
Professor Wang
Solutions to Problem Set #8
1
a.
Apply the CAPM to calculate the cost of equity.
r
S
=
R
F
+
β
S
×
(
R
M
–
R
F
)
= 0.06 + 1.15 (0.1)
=
0.175
The cost of equity is 17.5%.
b.
To calculate the weighted average cost of capital for the project, r
WACC
, first
determine the cost of debt, r
B
.
Use the cost of equity, r
S
, calculated in part (
a
).
r
B
=
R
F
+
β
B
×
(
R
M
–
R
F
)
= 0.06 + 0.3 (0.1)
= 0.09
r
S
= 0.175
Next, calculate the weighted average cost of capital.
To determine the proper
weights, express the firm’s proportion of debt in terms of the firm’s proportion of
equity.
Solve for the equity to value ratio [S / (S+B)] and the debt to value ratio
[B / (S+B)].
B / S
= 0.25
B
= 0.25 S
[S / (S+B)]
= [S / (S + 0.25
×
S)]
= [S / (1.25
×
S)]
= 1 / 1.25
= 0.80
[B / (S+B]
= [0.25
×
S / (S + 0.25
×
S)]
= [(0.25
×
S) / (1.25
×
S)]
= 1 / 5
= 0.20
Interest on debt is tax deductible at the corporate level, which leads to tax
benefits for the firm.
Multiply the cost of debt, r
B
, by (1  T
C
), to include the tax
benefit created by the interest tax shield.
The tax benefit of debt will lower the
firm’s overall cost of capital.
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 Spring '10
 Xiao
 Finance, Cost Of Capital, Weighted average cost of capital, weighted average cost, RWACC

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