company is financed by both debt and common equity, and the market value of debt is 25% and equity is 75% of the total enterprise value. The corporate tax rate is 21%. Assume that the current long-term risk free interest rate is 2.5%, and the company’s debt yields 100bps over the long-term risk free rate. The historical bond risk premium has been 1.5%, and the historical equity risk premium has been 7.7%. Using the Brealey & Myers technique to determine the risk-free rate for the purposes of calculating equity beta, the beta of the company’s stock is 1.6. The company’s after-tax WACC is 10.68125% 1. For the company above, assuming the dollar amount of the debt is kept constant through time, what is the stock’s unlevered beta? 2. If the company above changed its financing so that the target ratio of the market value of
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
A company is financed by both debt and common equity, and the market value of debt is 25% and equity is 75% of the total enterprise value. The corporate tax rate is 21%. Assume that the current long-term risk free interest rate is 2.5%, and the company’s debt yields 100bps over the long-term risk free rate. The historical bond risk premium has been 1.5%, and the historical equity risk premium has been 7.7%. Using the Brealey & Myers technique to determine the risk-free rate for the purposes of calculating equity beta, the beta of the company’s stock is 1.6. The company’s after-tax WACC is 10.68125%
1. For the company above, assuming the dollar amount of the debt is kept constant through time, what is the stock’s unlevered beta?
2. If the company above changed its financing so that the target ratio of the market value of Debt to the market value of Equity ratio were 15%/85%, what would the stock’s beta be?
3. And based on the 15%/85% Debt/Equity ratio, what would the after-tax WACC be?
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