The common stock of a firm has a beta of 1

Finance Nov 03, 2020

The common stock of a firm has a beta of 1.15. The Treasury bill rate is 3.5%, and the market risk premium is estimated at 7%. Firm’s capital structure is 40% debt, paying a 6.5% interest rate, and 60% equity. Firm pays tax at 35%.

a. What is the firm’s cost of equity?

b. What is its WACC?

c. If the firm is presented with an average risk project that has an internal rate of return of 15%, should it accept the project?

Expert Solution

Answer :

a. Cost of equity = Risk free rate + beta(market risk premium)

Cost of equity = 3.5 + 1.15(7) ==> 11.55

b. WACC = Weight of equity * Cost of equity + Weight of debt * after tax interest rate

WACC = 60% * 11.55 + 40% * 6.5(1-0.35)

WACC = 6.93 + 1.69

WACC = 8.62

c. If IRR is more than WACC, then we accept the project. So we should accept the project.

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