California Best (CB), a sports shoes store, expects an operating income of $2.3 million this year. CB has no long-term debt. The firm is considering as expansion project. The current risk-free rate of return is 7%, and the current market risk premium is 8.3%. If CB's beta is 20% greater than the overall market, what is the firm's cost of capital? Assume that CB has a marginal tax rate of 40%.

Question

Quizplus · Accepted Answer

The first step is to calculate the required rate of return for CB using the capital asset pricing model (CAPM):
Required rate of return = Risk-free rate + Beta x Market risk premium
= 7% + 1.2 x 8.3%
= 17.96%
Next, we need to adjust for taxes using the following formula:
After-tax cost of debt = Pretax cost of debt x (1 - Marginal tax rate)
Since CB has no long-term debt, we will assume that all of its financing comes from equity. Therefore, the cost of equity is equal to the required rate of return calculated using CAPM:
Cost of equity = 17.96%
Finally, we can calculate the weighted average cost of capital (WACC) using the following formula:
WACC = (Cost of equity x Equity weight) + (Cost of debt x Debt weight)
Since CB has no debt, the WACC is equal to the cost of equity calculated above:
WACC = 17.96% x 100% = 16.96%

California Best (CB), a Sports Shoes Store, Expects an Operating