Thunderhorse Oil is a U.S. oil company. Its current cost of debt is 6.70?%, and
ID: 2656848 • Letter: T
Question
Thunderhorse Oil is a U.S. oil company. Its current cost of debt is 6.70?%, and the? 10-year U.S. Treasury? yield, the proxy for the? risk-free rate of? interest, is 4.00?%. The expected return on the market portfolio is 8.20?%. The? company's effective tax rate is 30?%. Its optimal capital structure is 45?% debt and 55?% equity.
a. If? Thunderhorse's beta is estimated at 0.90?, what is? Thunderhorse's weighted average cost of? capital?
b. If? Thunderhorse's beta is estimated at 0.50?, significantly lower because of the continuing profit prospects in the global energy? sector, what is? Thunderhorse's weighted average cost of? capital? ROUND TO 2 DECIMAL PLACES
Explanation / Answer
Cost of equity:
Company
Risk free rate
Market Return
Beta
CAPM Working
Expected return
Stocks
Rf
Rm
B
Ri = Rf+B*(Rm-Rf)
Ri = Rf+B*(Rm-Rf)
Case a
4.00%
8.20%
0.90
=4%+0.90*(8.2%-4%)
7.78%
Case b
4.00%
8.20%
0.50
=4%+0.50*(8.2%-4%)
6.10%
WACC = Cost of equity x Weight of equity + Cost of debt x Weight of debt x (1-Tax rate)
a.
WACC = 7.78% x 55% + 6.70% x 45% x (1-30%)
WACC = 6.39%
.
b.
WACC = 6.10% x 55% + 6.70% x 45% x (1-30%)
WACC = 5.47%
Company
Risk free rate
Market Return
Beta
CAPM Working
Expected return
Stocks
Rf
Rm
B
Ri = Rf+B*(Rm-Rf)
Ri = Rf+B*(Rm-Rf)
Case a
4.00%
8.20%
0.90
=4%+0.90*(8.2%-4%)
7.78%
Case b
4.00%
8.20%
0.50
=4%+0.50*(8.2%-4%)
6.10%
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