Question

Gnomes R Us is considering a new project. The company has a debt-equity ratio of .62. The company’s cost of equity is 11.8 percent, and the aftertax cost of debt is 4.9 percent. The firm feels that the project is riskier than the company as a whole and that it should use an adjustment factor of +3 percent.What is the WACC it should use for the project?

Answer 1

Answer:

9.18%

Explanation:

Data provided in the question:

Debt-equity ratio = 0.62

Company’s cost of equity = 11.8%

After-tax cost of debt = 4.9%

Adjustment factor = +3%

Now,

Debt ÷ equity = 0.62

Debt = 0.62 × Equity

Thus,

Weight of debt = Debt ÷ [ Debt + Equity ]

= ( 0.62 × Equity ) ÷ [ 0.62 × Equity + Equity ]

= 0.62 ÷ 1.62

= 0.388

Weight of Equity = Equity ÷ [ Debt + Equity ]

= Equity ÷ [ 0.62 × Equity + Equity ]

= 1 ÷ 1.62

= 0.617

WACC

= ( Cost of Debt × Weight of Debt ) + ( Cost of Equity × Weight of Equity )

= ( 4.9% × 0.388 ) + ( 11.8% × 0.617 )

= 1.9012% + 7.2806%

= 9.18%