Question

Harris, Inc., has equity with a market value of $23.7 million and debt with a market value of $9.48 million. Treasury bills that mature in one year yield 6 percent per year and the expected return on the market portfolio is 11 percent. The beta of the company's equity is 1.22. The company pays no taxes. a. What is the company's debt-equity ratio?

b. What is the company's weighted average cost of capital?
c. What is the cost of capital for an otherwise identical all-equity company?

Answer 1

a. The company's debt-equity ratio is 0.4. b. The company's weighted average cost of capital is 9.1%. c. The cost of capital for an all-equity company would be 11.1%.

Step-by-step explanation:

a. The company's debt-equity ratio can be calculated using the formula: Debt/Equity. Given that the market value of the equity is $23.7 million and the market value of the debt is $9.48 million, the debt-equity ratio is $9.48 million/$23.7 million = 0.4.

b. The weighted average cost of capital (WACC) can be calculated using the formula: WACC = (Equity/(Equity + Debt)) * Cost of Equity + (Debt/(Equity + Debt)) * Cost of Debt. Since the company pays no taxes, the cost of debt is equal to the treasury bill rate of 6%. To calculate the cost of equity, we first need to calculate the risk premium, which is the expected return on the market portfolio minus the risk-free rate. The risk premium is 11% - 6% = 5%. The cost of equity can then be calculated using the formula: Cost of Equity = Risk-Free Rate + (Beta * Risk Premium). Given that the beta of the equity is 1.22, the cost of equity is 6% + (1.22 * 5%) = 11.1%. Substituting these values into the WACC formula, we get WACC = (23.7 million/(23.7 million + 9.48 million)) * 11.1% + (9.48 million/(23.7 million + 9.48 million)) * 6% = 9.1%.

c. The cost of capital for an otherwise identical all-equity company would be the cost of equity, which is 11.1%.