Spam Corp. is financed entirely by common stock and has a beta of 1.0. The firm

Question

Spam Corp. is financed entirely by common stock and has a beta of 1.0. The firm is expected to generate a level, perpetual stream of earnings and dividends. The stock has a price-earnings ratio of 8 and a cost of equity of 12.5%. The company's stock is selling for S50. Now the firm decides to repurchase half of its shares and substitute an equal value of debt. The debt is risk-free, with a 5% interest rate. The company is exempt from corporate income taxes. Assuming MM are correct, calculate the following items after the refinancing a. b. The cost of equity The overall cost of capital (WACC)

Explanation / Answer

Cost of Equity = 1/Price Earnings Ratio

=1/8

=0.125 or 12.50%

Calculation of WACC

WACC =8.75%

Source Proportion % WACC Equity 0.50 12.50% 6.25%(12.50*0.50) Debt 0.50 5% 2.50% WACC 8.75%

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.