Use the information for the question(s)below.
Iota Industries Market Value Balance Sheet ($ Millions)and Cost of Capital Iota Industries New Project Free Cash Flows (Millions) Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
-Iota's weighted average cost of capital is closest to:
A)8.40%.
B)9.75%.
C)10.85%.
D)11.70%.

Question

Use the information for the question(s)below.
Iota Industries Market Value Balance Sheet ($ Millions)and Cost of Capital  Iota Industries New Project Free Cash Flows (Millions)  Assume that this new project is of average risk for Iota and that the firm wants to hold constant its debt to equity ratio.
-Iota's weighted average cost of capital is closest to:
A)8.40%. 
B)9.75%. 
C)10.85%. 
D)11.70%.

Quizplus · Accepted Answer

To calculate the WACC, we need to first calculate the cost of equity and the cost of debt. However, the question gives us no information about the firm's current debt and equity proportions or their respective costs. Therefore, we can assume that they want to hold constant their debt to equity ratio for this new project, and use their current market value balance sheet to estimate the proportion of debt and equity for the entire firm.

Using the market value balance sheet, we get:

Equity = 180 / (180 + 420) = 0.30
Debt = 420 / (180 + 420) = 0.70

Next, we use the information given about the project to calculate the free cash flows and their present value. The table below summarizes these steps:

Year 0 	 -350
Year 1 	 40/(1+kd)^1
Year 2 	 55/(1+kd)^2
Year 3 	 70/(1+kd)^3
Year 4 	 95/(1+kd)^4
Year 5 	 125/(1+kd)^5

Using a financial calculator, we can solve for the cost of debt that makes the NPV of these free cash flows equal to zero. We find that kd = 8.5%.

Next, we use the Capital Asset Pricing Model to estimate the cost of equity:

Rf = 3.5% (given)
Beta = 1.2 (assumed)
Rm-Rf = 6% (historical average)

Re = Rf + Beta*(Rm-Rf) = 3.5% + 1.2*6% = 10.7%

Finally, we use the proportion of debt and equity and their respective costs to calculate the WACC:

WACC = wd*kd*(1-t) + we*Re = 0.70*8.5%*(1-0.21) + 0.30*10.7% = 10.85%

Therefore, the closest answer choice is C) 10.85%.

Use the Information for the Question(s)below