Question

QUESTION 2 A company uses only debt and equity to finance its capital budget. The company uses CAPM to compute the cost of equity and estimates that WACC is 12%. The capital structure of the company is 75% debt and 25% equity. The following additional information is provided: • Risk-free rate- 6%; • Return on the market 14%; • Tax rate 20%; and • Cost of Debt 12.5%. a) Compute the beta of the company?

Answer 1

WACC = Weight of Debt *After tax Cost of Debt + Weight of equity * cost of equity

12% = 75% * 12.5%*(1-20%) + 25%*cost of equity

12% = 7.5%+ 25% * Cost of equity

12% - 7.5% = 25% * Cost of equity

Cost of equity = 18%

Required return = Risk free rate + (Return on Market - Risk free rate) * beta

18% = 6% +( 14%-6%) * Beta

Beta = (18%-6%) / 8%

= 1.5

Answer = 1.5