Question

Bagels Inc. has a target capital structure of 40% debt, 5% preferred stock and 55% common equity. DBI’s before-tax cost of debt is 8% and marginal tax rate is 25%. Preferred stockholders require a 3.25% return. Currently the firm’s beta is 0.25. Using a market return of 11.0% and risk-free rate of 2.0%, what is Daigle’s Bagels’
a) cost of equity? (3 points)
b) WACC? (7 points)

Answer 1

Cost of Equity = Rf + beta (Rm - Rf)

= 2% + 0.25 (11% - 2%)

= 4.25%

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt) + (Cost of Preferred Stock * Cost of Preferred Stock)

= 4.25% * 0.55 + 8% * (1-0.25) * 0.40 + 3.25% * 0.05

= 4.9%

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