sol8 - FIN300 Introduction to Managerial Finance Professor...

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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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sol8 - FIN300 Introduction to Managerial Finance Professor...

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