The market value of Fortescue's ordinary shares, preference shares and debt are $7 billion, $3 billion and $10 billion, respectively. Fortescue has a beta of 1.8, the market risk premium is 7%, and the risk-free rate of interest is 4%. Fortescue's preference shares pay a dividend of $3.5 each year and trades at a price of $27 per share. Fortescue's debt trades with a yield to maturity of 9.5%. What is Fortescue's weighted average cost of capital if its tax rate is 30%?

Question

Quizplus · Accepted Answer

First, 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
Cost of equity = 0.04 + 1.8 * 0.07 = 0.1456 or 14.56%
Next, we need to calculate the cost of preference shares:
Cost of preference shares = Dividend / Price
Cost of preference shares = 3.5 / 27 = 0.1296 or 12.96%
Then, we need to calculate the after-tax cost of debt:
After-tax cost of debt = Yield to maturity * (1 - Tax rate)
After-tax cost of debt = 0.095 * (1 - 0.3) = 0.0665 or 6.65%
Finally, we can calculate the weighted average cost of capital (WACC) using the weights of each component:
WACC = (Market value of equity / Total market value) * Cost of equity + (Market value of preference shares / Total market value) * Cost of preference shares + (Market value of debt / Total market value) * After-tax cost of debt
WACC = (7 / 20) * 0.1456 + (3 / 20) * 0.1296 + (10 / 20) * 0.0665 = 0.1108 or 11.08%
Therefore, the best choice is (C), 11.08%.

The Market Value of Fortescue's Ordinary Shares, Preference Shares and Debt