Final answer:
To estimate the firm's Weighted Average Cost of Capital (WACC), we combine the cost of equity, calculated using the CAPM formula, and the cost of debt, accounting for their respective weights in the capital structure. Given a debt-to-equity ratio of 1 to 1, the cost of equity was found to be 14.82%, and the approximation for the cost of debt was 4.27%, resulting in an estimated WACC of 9.545%.
Step-by-step explanation:
To estimate the firm's cost of capital, which is also known as the Weighted Average Cost of Capital (WACC), we must take into account the cost of equity and the cost of debt, adjusted for the respective weightings according to the firm's capital structure. Given the firm's debt-to-equity ratio of 1 to 1, the total weight of equity is 0.5, and the total weight of debt is also 0.5.
The cost of equity (Re) can be calculated using the Capital Asset Pricing Model (CAPM), which is Re = risk-free rate + beta * (market rate of return - risk-free rate). Plugging in the given values, Re = 2.2% + 1.8 * (9.1% - 2.2%) = 14.82%. The cost of debt (Rd) should be adjusted for tax since interest expense is tax-deductible. However, since the tax rate is not provided, we will use the risk-free rate plus the debt beta multiplied by the market risk premium as an approximation for the cost of debt here: Rd = 2.2% + 0.3 * (9.1% - 2.2%) = 4.27%.
Now we can calculate WACC = (weight of equity * cost of equity) + (weight of debt * cost of debt), which gives us WACC = (0.5 * 14.82%) + (0.5 * 4.27%) = 9.545%. Thus, a good estimate for your firm's cost of capital is 9.545%.