The weighted average cost of capital (WACC) is a metric that calculates the average cost of all sources of a company's capital, including equity and debt, by weighting the cost of each source based on its relative size within the company's capital structure.
To calculate Gamma Corp's WACC, we need to first calculate the cost of equity and the cost of debt.
Cost of equity:
The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM):
Cost of equity = Risk-free rate + (Equity beta * Market risk premium)
Cost of equity = 4% + (1.00 * 5%)
Cost of equity = 9%
Cost of debt:
The cost of debt is simply the interest rate that the company pays on its outstanding debt:
Cost of debt = 4.5%
Next, we need to determine the relative weight of each type of financing in the company's capital structure. This can be done by dividing the market value of each type of financing by the total market value of the company's capital:
Market value of debt = $100 million
Market value of equity = $300 million
Total market value of capital = $100 million + $300 million = $400 million
Weight of debt = Market value of debt / Total market value of capital = $100 million / $400 million = 0.25
Weight of equity = Market value of equity / Total market value of capital = $300 million / $400 million = 0.75
Finally, we can calculate the WACC by taking a weighted average of the cost of debt and the cost of equity:
WACC = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity)
WACC = (0.25 * 4.5%) + (0.75 * 9%)
WACC = 6.375%
So, Gamma Corp's WACC is 6.375%.
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Problem 2:
The cost of equity can be calculated as follows:
Cost of equity = Risk-free rate + (Equity beta * Market risk premium)
Market risk premium = Expected return of the market portfolio - Risk-free rate
Market risk premium = 8% - 3% = 5%
Cost of equity = 3% + (0.57 * 5%)
Cost of equity = 3% + 2.85% = 5.85%
So, Alpha Corporation's equity cost of capital is 5.85%.
This post was edited by swmtrunks on Feb 11 2023 02:34am