Suppose a firm's stock valuation is worth three times its outstanding debt. The firm's stock earns an annual return of 6 percent and pays 8 percent on the outstanding debt. What is the firm's company cost of capital?

Question

Quizplus · Accepted Answer

The first step is to find the weights of debt and equity. Since the stock valuation is worth three times the outstanding debt, we can assume that the firm has one unit of debt and three units of equity.

Weight of debt = 1 / (1 + 3) = 0.25
Weight of equity = 3 / (1 + 3) = 0.75

Next, we need to calculate the cost of equity using the capital asset pricing model (CAPM):

Cost of equity = risk-free rate + beta * market risk premium
Assuming the risk-free rate is 2 percent and the equity's beta is 1 (which is average), we can use the market risk premium as the difference between the equity return and the risk-free rate:

Market risk premium = 6% - 2% = 4%

Cost of equity = 2% + 1 * 4% = 6%

Finally, we can calculate the weighted average cost of capital (WACC) using the weights and costs of debt and equity:

WACC = (0.25 * 8%) + (0.75 * 6%) = 6.5%

Suppose a Firm's Stock Valuation Is Worth Three Times Its