Question

You are tasked with estimating the cost of capital for a firm. The risk-free rate is 3.6%, the expected rate of return on the market is 12.7%. Now, another similar company (similar unlevered cost of capital) has a debt-to-equity ratio of 1 to 2. It has a debt beta near zero and an equity market-beta of 1.6. Your own firm has more debt, for a debt-to-equity ratio of 1 to 1, with a debt beta of 0.3. What is a good estimate for your firm's cost of capital (WACC)?

Answer 1

The cost of capital for a firm can be estimated using the weighted average cost of capital (WACC) formula. To estimate the WACC, you need to calculate the weight of debt and equity, the cost of debt, the cost of equity, and then apply the WACC formula using these values.

Step-by-step explanation:

The cost of capital for a firm can be estimated using the weighted average cost of capital (WACC) formula. WACC is calculated by taking a weighted average of the cost of debt and the cost of equity.

In this case, your firm has a debt beta of 0.3 and a debt-to-equity ratio of 1 to 1. The debt beta near zero for the similar company with a debt-to-equity ratio of 1 to 2 is not relevant for your firm's estimation.

To estimate your firm's WACC, you can use the following steps:

1. Calculate the weight of debt and equity: Debt/(Debt + Equity) = Debt/(Debt + Debt) = 0.5
2. Calculate the cost of debt: Debt Beta * Risk-Free Rate
3. Calculate the cost of equity: Equity Market-Beta * (Expected Rate of Return on Market - Risk-Free Rate)
4. Calculate the WACC: (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)

By plugging in the given values, you can calculate your firm's cost of capital using the WACC formula.