8. Faris currently has a capital structure of 40 percent debt and 60 percent equ

Question

8. Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax rate of 40 percent. Faris' tax rate is 40 percent. What will be Faris' weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and themarket risk premium is 5 percent?

A. 12.15%

B. 11.41%

C. 18.15%

D. 14.27%

Explanation / Answer

Unlevered beta = Levered Beta/(1+ D/E*(1-tax rate)

Unlevered beta = 1.6/(1+ 40/60*(1-40%))

Unlevered beta = 8/7

Levered Beta of Faris = Unlevered beta *(1+ D/E*(1-tax rate)

Levered Beta of  Faris = 8/7 *(1+70/30*(1-40%))

Levered Beta of  Faris = 19.20/7

Cost of Common Stock = Rf + (Rm-Rf)*Beta

Cost of Common Stock = 8 + 5*19.20/7

Cost of Common Stock = 21.71%

WACC = Weight of Common Stock* Cost of Common Stock + Weight of Debt* After Tax cost of Debt

WACC = 30%*21.71% + 70%*7%

WACC = 11.41%

Answer

B) 11.41%

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