Question

The current capital structure of Amgel Manufacturing Company has 30% debt and 70% equity (based on market values). While the beta Amgel equity (based on your current level of debt financing) is 1.20, its debt is beta 0.29. In addition, the rate of risk free rate is currently 4.5% on government bonds in the long term. The Amgel investment banker advised the firm in stating that estimates the market risk premium is 5.25%.
1. What is your estimate of the cost of equity for Amgel (based on the CAPM)?

2. If the marginal tax rate is 35% Angel, what is the weighted average cost of capital (WACC) of that organization?

3. Amgel provides significantly expand operations. The investment banker believes that Amgel firm may borrow up to 40% of the necessary funds and maintain its current credit rating and the cost of borrowing. WACC estimate for this project

Answer 1

Answer:

1. 10.8%

2. 8.734%

3. 8.04585%

Explanation:

1. The computation of the estimated cost of equity is shown below:

Based on the Capital Asset Pricing Model, the cost of equity would be

= Risk-free rate + Beta × market risk premium

= 4.5 + 1.20 × 5.25

= 4.5 + 6.3

= 10.8%

2. Before computing the WACC first, we need to find out the cost of debt based on CAPM model which is shown below:

= Risk-free rate + Beta × market risk premium

= 4.5 + 0.29 × 5.25

= 4.5 + 1.5225

= 6.0225%

Now the WACC would be equal to

= Weightage of debt × cost of debt × ( 1- tax rate) + (Weightage of  equity) × (cost of equity)

= (0.3 × 6.0225%) × ( 1 - 35%) +  (0.7× 10.8%)

= 1.174% + 7.56%

= 8.734%

3. If debt weighatge is 40%, so the equity weighatge would be 60% than the WACC would be

= Weightage of debt × cost of debt × ( 1- tax rate) + (Weightage of  equity) × (cost of equity)

= (0.4 × 6.0225%) × ( 1 - 35%) +  (0.6× 10.8%)

= 1.56585% + 6.48%

= 8.04585%