Solved Question: Corcovado Pharmaceutical’s cost of debt is 7.60%

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Question:

Corcovado Pharmaceutical’s cost of debt is 7.60%. The risk-free rate of interest is 4.00%. The expected return on the market portfolio is 8.60%. Corcovado’s effective tax rate is 39%. Its optimal capital structure is 75% debt and 25% equity.

Please answer the following questions? ​(Round to two decimal​ places.)

1. If Corcovado’s beta is estimated at 1.80 what is its weighted average cost of capital?

2. If Corcovado’s beta is estimated at 1.40, significantly lower because of the continuing profit prospects in the global energy sector, what is its weighted average cost of capital?

Answer:

Part 1.

Cost of Equity = Risk Free Rate + Beta * (Market Return – Risk Free Rate)

Risk Free Rate = 4% or 0.04
Market return = 8.60% or 0.086
Beta = 1.80

Cost of Equity = 0.04 + 1.80 * (0.086 – 0.04)
Cost of Equity = 0.04 + 1.80 * 0.046
Cost of Equity = 0.04 + 0.0828
Cost of Equity = 0.1228 or 12.28%

Cost of Debt = 7.60%
Tax Rate = 39%
After Tax Cost of Debt = 0.076 * (1 – 0.39)
After Tax Cost of Debt = 0.04636 or 4.636%

WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of Equity * Cost of Equity)
WACC = (0.75 * 0.04636) + (0.25 * 0.1228)
WACC = 0.03477 + 0.0307
WACC = 0.06547 or 6.55%

Part 2.

Cost of Equity = Risk Free Rate + Beta * (Market Return – Risk Free Rate)

Risk Free Rate = 4% or 0.04
Market return = 8.60% or 0.086
Beta = 1.40

Cost of Equity = 0.04 + 1.40 * (0.086 – 0.04)
Cost of Equity = 0.04 + 1.40 * 0.046
Cost of Equity = 0.04 + 0.0644
Cost of Equity = 0.1044 or 10.44%

Cost of Debt = 7.60%
Tax Rate = 39%
After Tax Cost of Debt = 0.076 * (1 – 0.39)
After Tax Cost of Debt = 0.04636 or 4.636%

WACC = (Weight of Debt * After Tax Cost of Debt) + (Weight of Equity * Cost of Equity)
WACC = (0.75 * 0.04636) + (0.25 * 0.1044)
WACC = 0.03477 + 0.0261
WACC = 0.06087 or 6.09%

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