Question

Gnomes R Us is considering a new project. The company has a debt-equity ratio of 62. The company's cost of equity is 11.8 percent, and the aftertax cost of debt is 4.9 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +3 percent. Skloped a. What is the company's WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What discount rate should the firm use for the project? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) a. WACC b. Project discount rate

Answer 1

a

D/A = D/(E+D)

D/A = 0.62/(1+0.62)

=0.3827

Weight of equity = 1-D/A

Weight of equity = 1-0.3827

W(E)=0.6173

Weight of debt = D/A

Weight of debt = 0.3827

W(D)=0.3827

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 4.9*(1-0)

= 4.9

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.9*0.3827+11.8*0.6173

WACC =9.16%

b

Project return = WACC+adj rate = 9.16+3 = 12.16%