Hatter Inc has equity with a market value of 221 million and

Hatter, Inc., has equity with a market value of $22.1 million and debt with a market value of $8.84 million. The cost of debt is 10 percent per year. Treasury bills that mature in one year yield 6 percent per year, and the expected return on the market portfolio over the next year is 11 percent. The beta of the company’s equity is 1.06. The firm pays no taxes.

a. What is the company’s debt?equity ratio? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Debt–equity ratio             

b. What is the company\'s weighted average cost of capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Weighted average cost of capital             %

c. What is the cost of capital for an otherwise identical all-equity firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of capital             %

Solution

(a) - Company’s Debt?Equity Ratio

Debt - Equity Ratio = Market Value of Debt / Market Value of Equity

= $8.84 Million / $22.10 Million

= 0.40

Hence, The Company’s Debt–Equity Ratio = 40%

(b) - Company\'s weighted average cost of capital [WACC]

Cost of Debt = 10%

Cost of Equity as per Capital Asset pricing Model = Rf + Beta[Rm – Rf]

= 6% + 1.03[11% - 6%]

= 6% + 5.30%

= 11.30%

Weight of Debt = $8.84 Million / $30.94 Million = 0.2857

Weight of Equity = $22.10 Million / $30.94 Million = 0.7143

Weighted average cost of capital [WACC] = [Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [10% x 0.2857] + [11.30% x 0.7143]

= 2.86% + 8.07%

= 10.93%

Therefore, The Company’s Weighted average cost of capital is 10.93%

(c) - The cost of capital for an otherwise identical all-equity firm

As per Modigliani–Miller Proposition II

Rs = R0 + (Debt / Equity) (R0 – R)

0.1130 = R0 + (8.84 / 22.10) (R0 – 0.1130)

By solving this, We will get R0 = 0.1093

Therefore, cost of capital for an otherwise identical all-equity firm is 10.93%