Question

CoffeeStop primarily sells coffee. It recently introduced a premium​ coffee-flavored liquor​ (BF Liquors). Suppose the firm faces a tax rate of 40 % and collects the following information. If it plans to finance 12 % of the new​ liquor-focused division with debt and the rest with​ equity, what WACC should it use for its liquor​ division? Assume a cost of debt of 5.4 %​, a​ risk-free rate of 3.5 %​, and a market risk premium of 6.9 %.

Answer 1

Answer:

Risk-free rate = 3.5%

Market risk-premium = 6.9%

Cost of equity (Ke) = ?

Ke = Rf +β(Rm - Rf)

Ke = Rf + Market risk premium

Ke = 3.5 + 6.9

Ke = 10.4%

Cost of debt (Kd) = 5.4%

Market value of debt (D) = 12

Market value of equity (E) = 88

Market value of the company (V) = 100

WACC = Ke(E/) + Kd(D/V)(1-T)

WACC = 10.4(88/100) + 5.4(12/100)(1-0.40)

WACC = 9.152 +  0.3888

WACC = 9.54%

Explanation:

In this case, there is need to calculate cost of equity according to capital asset pricing model, which is risk-free rate plus market risk-premium.

Then, we will calculate the weighted average cost of capital, which equals cost of equity multiplied by the proportion of equity in the capital  structure plus after-tax cost of debt multiplied by the proportion of debt in the capital structure. Since the proportion of debt in the capital structure is 12%(12/100), the proportion of equity will be 88%(88/100).