Amalgamated Foods needs to estimate the cost of capital for the evaluation of ca

Question

Amalgamated Foods needs to estimate the cost of capital for the evaluation of capital expenditures. A typical project is financed with 40% debt-to-value ratio (i.e., D/(D+E) = 0.4). United Foods, a publicly traded firm in the same business as Amalgamated Foods, is financed with 30% debt-to-value ratio and has a Beta of 0.8. For both corporations, the cost of debt is 6% and the corporate tax rate is 40%. Assume that the risk-free rate is 5% and the expected market risk premium is 7%.

Target Firm: Amalgamated Foods

Comparable Firm: United Foods

a) Find the cost of equity of Amalgamated Foods.

b) Find the WACC for Amalgamated Foods.

Explanation / Answer

a). Required rate of return= risk free rate + beta * expected market risk premium

= 5% + 0.8 * 7%

= 5% + 5.6%

= 10.6%

cost of equity of Amalgamated Foods = 10.6%

b). Cost of debt (after tax) = 6% * (1-0.4)

= 3.6%

So, WACC for Amalgamated Foods = 7.8%

Note :- debt-to-value ratio = 40% ;

Debt = 40%

equity= 60%

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