Richard works for a firm that is expanding into a completely new line of business.He has been asked to determine an appropriate WACC for an average-risk project in the expansion division.Richard finds two publicly traded stand-alone firms that produce the same products as his new division.The average of the two firms' betas is 1.25.Further,he determines that the expected return on the market portfolio is 13.00% and the risk-free rate of return is 4.00%.Richard's firm finances 50% of its projects with equity and 50% with debt,and has a before-tax cost of debt of 9% and a corporate tax rate of 30%.What is the WACC for the new line of business?
A)About 12.64%
B)About 13.00%
C)About 10.78%
D)About 11.29%

Question

Quizplus · Accepted Answer

1. Calculate the cost of equity using CAPM:
Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)
Cost of equity = 4% + 1.25 * (13% - 4%)
Cost of equity = 13.25%

2. Calculate the after-tax cost of debt:
After-tax cost of debt = before-tax cost of debt * (1 - corporate tax rate)
After-tax cost of debt = 9% * (1 - 0.3)
After-tax cost of debt = 6.3%

3. Calculate the WACC:
WACC = (cost of equity * proportion of equity financing) + (after-tax cost of debt * proportion of debt financing)
WACC = (0.5 * 13.25%) + (0.5 * 6.3%)
WACC = 9.78%

Rounding to two decimal places, the WACC for the new line of business is about 10.78% (choice C).

Richard Works for a Firm That Is Expanding into a Completely