A company has a debt-to-equity ratio of 1:3.The firm is able to borrow at the risk-free rate of 6% per year.The interest expense is tax deductible,and the corporate tax rate is 35%.Assuming that the CAPM holds,the expected return of the market portfolio is 12%,and the beta of the firm's equity is 1.5,what is the firm's WACC?

Question

Quizplus · Accepted Answer

WACC = E/V * Re + D/V * Rd * (1-T)

where:
E = Market value of equity
D = Market value of debt
V = E + D
Re = cost of equity
Rd = cost of debt
T = tax rate

Given:
Debt-to-equity ratio = 1:3 implies D/V = 1/4 and E/V = 3/4
Risk-free rate (Rf) = 6%
Corporate tax rate (T) = 35%
Expected return of market portfolio (Rm) = 12%
Beta of equity (β) = 1.5

Cost of equity (Re) = Rf + β * (Rm - Rf) = 6% + 1.5 * (12% - 6%) = 15%
Cost of debt (Rd) = Rf = 6% (since borrowing is at the risk-free rate)

WACC = (3/4) * 15% + (1/4) * 6% * (1 - 35%) = 12.23%

A Company Has a Debt-To-Equity Ratio of 1:3