Question

• You are a business analyst tasked with determining the WACC (weighted average cost of capital) of Phil's Garlic Ice Cream, Inc. based in Gilroy, CA. You have collected the following data: EN = 0.4 D/V = 0.6 Cost of debt (Rd) = 0.054 Effective tax rate (Te) = 0.11 Rm = 0.13 Rp = 0.016 The company has been public for 2 years and you know the following about their stock (and the general stock market): Year %change in share price %change in the market 1 +8% +10% 2 +2% +0.88% Find the WACC for Phil's Garlic Ice Cream, Inc.

Answer 1

The covariance between stock return and market returns as well as variance of market returns is calculated as

$Covariance (R_{s}, R_{m})= \sum_{i=1}^{n} {(R_{si}-\bar{R_{i}})* (R_{mi}-\bar{R_{m}})}/(n-1)$

$variance (R_{m})= \sum_{i=1}^{n} (R_{mi}-\bar{R_{m}})^{2}/(n-1)$

Mean of stock return = (0.08+0.02)/2=.0.05

Mean of market return = (0.10+0.0088)/2=.0.0544

So Covariance between returns of stock and market =

{(0.08-0.05)*(0.1-0.0544) + (0.02-0.05)*(0.0088-0.0544)}/(2-1) = 0.002736

Variance of market returns = {(0.1-0.0544)^2+ (0.0088-0.0544)^2}/(2-1) =0.004159

So, Beta of stock = Covariance between stock and market returns/ variance of market returns

=0.002736/0.004159= 0.66

From CAPM model

Cost of equity = Rf + beta* (Rm - Rf) = 0.016 + 0.66*(0.13-0.016)

= 0.091 or 9.1%

So, WACC = E/V *Cost of Equity + D/V * Cost of debt * (1-tax rate)

=0.4*0.091 + 0.6* 0.054*(1-0.11)

= 0.065236 = 6.5236%