Jiminy Cricket Farm has a capital structure that includes long term debt with bo
ID: 2654347 • Letter: J
Question
Jiminy Cricket Farm has a capital structure that includes long term debt with book value debt of $100,000 and equity with book value of $200,000. The coupon rate on the debt is 6 percent but the current yield to maturity is 7%. The Beta on the equity is 2.0 and the Market Value/Book Value ratio for equity is 1.5 times. You may assume that the debt generally trades close to its book value. In other words, the market value and book value of debt are generally the same. Calculate, using market value weights, the Weighted Average Cost of Capital. The tax rate is 35 percent, the risk free rate is 3% and the market risk premium is 8.2 percent.
Explanation / Answer
Market value of equity = Book value * 1.5
= $200,000 * 1.5
= $300,000
Cost of equity = Risk free rate + beta * Market risk premium
= 3% + 2.0 * 8.2%
= 19.4%
Weighted Average Cost of Capital = Weightage of debt * Cost of debt * (1 - tax rate) + Weightage of equity * Cost of equity
= ($100,000 / $400,000) * 7.0% * (1 - 35%) + ($300,000 / $400,000) * 19.4%
= 15.69%
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