Question

Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax rate of 40 percent. Faris' tax rate is 40 percent. What will be Faris' weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and the market risk premium is 5 percent?

A. 12.15%

B. 11.41%

C. 18.15%

D. 14.27%

Answer 1

11.41%

Step-by-step explanation:

Unlevered beta for new division:

= Levered beta ÷ [1 + (1 - tax) × D/E]

= 1.6 ÷ [1 + (1 - 40%) × (40 ÷ 60) ]

= 1.14

Beta for Faris's new division:

= Unlevered beta × [(1 + (1 - tax) × D/E]

= 1.14 × [1 + (1 - 40%) × (70 ÷ 30)]

= 2.74

Using CAPM,

Cost of equity, re = Rf + (beta × MRP)

= 8% + (2.74 × 5%)

= 21.71%

WACC:

= (wd × rd) + (we × re )

= (70% × 7%) + (30% × 21.71% )

= 11.41%