Assume a firm can be financed with $400 of debt that has a market beta of 0.2 and $600 of equity that has a beta of 2.0. If the risk-free rate is 3.5% and the equity premium is 5%, what is
The cost of capital of the overall firm?

Question

Quizplus · Accepted Answer

The cost of capital for the overall firm can be calculated using the weighted average cost of capital (WACC) formula, which takes into account the cost of equity, the cost of debt, and their respective proportions in the firm's capital structure. The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is given by the formula: Cost of Equity = Risk-Free Rate + Beta * Equity Premium. For the equity, this would be 3.5% + 2.0 * 5% = 13.5%. The cost of debt is calculated similarly, but since the beta of debt is lower, its cost is lower: 3.5% + 0.2 * 5% = 4.5%. The overall WACC is the weighted average of these costs, taking into account the proportion of debt and equity in the firm's financing: WACC = (400/1000)*4.5% + (600/1000)*13.5% = 1.8% + 8.1% = 9.9%.

Assume a Firm Can Be Financed with $400 of Debt