The Super Muench Cookie Company has a capital structure consisting of 30% debt and 70% equity based on market values. Company's equity beta based on its current level o debt financing is 1.8 and its debt beta is 0.6. Also, the risk free rate of interest is currently 3% on long-term government bonds. The company's pre-tax cost of debt is 9%. Investment banker advised the firm that according to her estimates, the market risk premium is 12%.
a. What is your estimate of the cost of equity capital for The Super Muench Cookie Company based on the CAPM?
b. If company's marginal tax rate is 30%, what is the firm's overall weighted average cost of capital?
c. The Super Muench Cookie Company is considering a diversification effort that would move it into small retail outlets at major malls around the country. Super Muench believes that for the riskier retail outlet portion of its business, a more conservative capital structure of 20% debt and 80% equity is more appropriate. Estimate WACC for the project.
use formulas (not excel)
a. Using CAPM
Cost of equity = Rf + (Rm-Rf) beta
Rf = risk free rate = 3%
(Rm-Rf) = market risk premium = 12%
beta = 1.8
Cost of equity = 3% + 12% X 1.8 = 24.6%
b. WACC = Proportion of debt X after tax cost of debt + Proportion of equity X cost of equity
Proportion of debt = 30%
The solution explains how to calculate the WACC for the company and for a project