Applied Finance : Group Activity 2

Class 1M12

Derian Osmond 2201920114

Haris Munandar 2201919964

You have been asked to estimate the cost of capital for the CAT corporation. The company
has 4 million shares and 125,000 bonds outstanding at par value $1,000. In addition, it has
$20 million in short-term debt from its bank. The target capital structure ratio is 55 percent
equity, 40 percent long-term debt, and 5 percent short-term debt. The current capital structure
has temporarily moved slightly away from the target ratio. The company’s shares currently
trade at $50 with a beta of 1.03. The book value of the shares is $16. The annual coupon rate
of the bonds is 9 percent, they trade at 108 percent of par, and they will mature in ten years.
Interest on the short-term debt is 3.5 percent. The current yield on ten-year government bonds
is 5.2 percent. The market risk premium is 5 percent. The corporate tax rate applicable is
expected to be 35 percent. Based on these data, calculate the cost of capital for the CAT
Corporation.

As known :

E D1 D2
WACC = k E +k D 1 ( 1−T ) + k D 2 ( 1−T )
E + D 1+ D 2 E+ D 1 + D 2 E+ D 1 + D 2

k E= cost of equity

E = amount of equity, given 4 million shares x the market value of $ 50 per share =
$200,000,000 on the books of the company. Please note that per the text we use market value
to calculate the equity, not book value.

k D 1= Cost of short term debt, given as 3.5 %

D1 = Amount of short term debt, given as $20,000,000

k D 2= Cost long term debt

D2 = Amount of debt, given as [ 125,000 bonds x $ 1000 per value=$ 125,000,000 ]

T = Corporate tax rate, given as 35%

Total capital = E + D1+ D2

= $200,000,000 + $20,000,000 + $125,000,000 = $ 245,000,000

D1 is short term debt, d2 is long term debt and E is the total equity of the firm

We need to calculate the cost of equity or k E .We can calculated the cost of equity with
CAPM with equation :

k E=¿ R F + ( RM −R F ) x β E ¿

R F= is the risk free market rate, given as 5.2% (5 year government bond rate)

R M = is the market rate. [ R M −R F ] is the market risk premium, which is given as 5%. Since we

know R F is 5.2 % and [ R M −R F ] is 5%. We can substitute to see that :

R M - 5.2% = 5%

=5% + 5.2%

=10.2%

Therefore R M equals 10.2%

β E = the beta of the firm equity, given as 1.03

If we substitute these values into our equation we got

k E= 5.2% + (10.2% - 5.2%) x 1.03 = 0.052 + 0.0515 = 0.1035 (10.35%)

$ 200 M $ 20 M $ 125 M
WACC = 10 .35 % x [ $ 345 M ][
+ 3.5 % ( 1−3 5 % )
$ 345 M][
+ 7.82 % ( 1−35 % )
$ 345 M ]
= [ 0.1035 x 0.5797 ] + [ 0. 02275 x 0. 05797 ] + [ 0. 05083 x 0.36232 ]

= 0,07973 (7,97%)
If we calculated with excel can be like
Answer :
a. We need to calculate the cost of capital for an airline division of a larger company.
The formula to use for this is the Weighted Average Cost of Capital (WACC). This
formula multiple the cost of each component in the scenario by its weight, meaning
the proportion of the total structure it provides :

E D
WACC=k E +k D (1−T )
E+ D E+ D
 k E isCost of Equity ,Calculated below
E= Amount of equity. The debt to equity ratio is to be calculated as the average of the

1.25+1.85+1.35+1.70+ 3.40
airlines shown in the table, so it would be [ 5 ]
=1.91 . This

means our debt will be 1.91 and our equity will be 1.00
k D= Cost of debt. This is to be calculated as the average of the airlines shown in the

6 % +7 % +7.50 %+7.25 % +8.50 %

table, so it would be [ 5 ]
=7.25 % .

D = Amount of debt. The debt to equity ratio is to be calculated as the average of the
airlines shown in the table, so it would be :
1.25 + 1.85 + 1.35 + 1.7 + 3.4 = 9.55 / 5 = 1.91
This means our debt will be 1.91 and our equity will be 1.00.
T = Corporate Tax Rate , given as 30%
E + D = Total Capital, calculated as 1.0 equity plus 1.91 debt = 2.91

We need to calculate the cost of equity or k E . In order to do that we,ll first need to calculate
β E = the beta of the division, we will average the 5 β asset values provided in the table

1.2+0.95+1.35+1.45+ 1.55
[ 5 ]
=1.3. This is our divisions estimated β E from our Airline A to

Airline E.
We can calculated the cost of equity or k E , using the capital asset pricing model (CAPM).
This model uses the equatiom
k E =Rf + ( R M −R F ) x β E
R F= the risk free market rate, given as 5 %
R M = the market rate. R M −R Fis the market risk premium, which is given as 5%. We know R F

is 5 %, and R M −R F IS 5%, we can substitute to see that R M −5 %=5 % and therefore R M

equals 10 %.
β E = the estimated beta of the division, calculated above as 1.3
k E= 5 % + (10%-5%) x 1.3
k E= 0.115 (11.5%)
Cost of Equity is 11.5%
We know have all the needed values for the WACC calculation of
E D 1.0 1.9
kE
E +D
+ k D ( 1−T )
E+ D [
= 11.5 %
2.9 ][
+ 7.25 % (1−30 %)
2.9 ]
=0.039655+0.0332499=0.0729049

Therefore, the divisions WACC is 7.29%.

b. The cost of capital we have calculated is higher than the cost of capital for the
company as a whole. If we use the company's lower WACC to discount the company
cash flows to present value, they will be discounted less and that will result in higher
results, for a higher total NPV and therefore a higher valuation.