Question 2. Weighted Average Cost of Capital (20 points) The Intel Corporation h

Question

Question 2. Weighted Average Cost of Capital (20 points) The Intel Corporation has a book value of capital of $10,000,000. All of its capital is equity capital which has a current market value of $100,000,000. s equity beta is 0.75. You have the following market information: The current 10-year Treasury bond rate is 3% The Market Risk Premium is 6.2% The tax rate is 35% a. Please estimate its Weighted Average Cost of Capital, given its current capital structure: b. The CFO of the Intel Corporation has decided to ask the Board to approve his proposal to change the Intel Capital Structure to 50% Debt/50% Equity in Market Value terms. For the change in Capital Structure, the CFO has collected the following information: Intel can borrow money in the long-term debt market at YTM of 7%, before taxes. With the proposed change in capital structure, the equity beta is expected to increase to 1.24 Please estimate the Weighted Average cost of capital, given the proposed capital structure

Explanation / Answer

a) Since currently the capital structure is comprised of only equity, the weighted average cost of capital (WACC) will be equal to the cost of equity. We will use CAPM to compute the cost of equity.

Cost of equity = Rf + b x MRP

where, Rf = risk free rate/ treasury bond rate, b = beta, MRP = Market risk premium

Cost of equity or WACC = 3% + 0.75 x 6.2% = 7.65%

b) After tax cost of debt = YTM x (1 - tax rate) = 7% x (1 - 0.35) = 4.55%

Cost of equity = 3% + 1.24 x 6.2% = 10.688%

Weight of equity = Weight of debt = 50% or 0.50

WACC = Cost of equity x Weight of equity + After tax cost of debt x Weight of debt

or, WACC = 10.688% x 0.50 + 4.55% x 0.50 = 7.619% or 7.62%

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