A firm has 5,000,000 shares of common stock outstanding, each with a market price of $8.00 per share. It has 25,000 bonds outstanding, each selling for $1,100 with a $1,000 face value. The bonds mature in 12 years, have a coupon rate of 9 percent, and pay coupons semiannually. The firm's equity has a beta of 1.4, and the expected market return is 15 percent. The tax rate is 21 percent and the WACC is 14 percent. Calculate the risk-free rate.
A) 3.90 percent
B) 15.27 percent
C) 20.18 percent
D) 1.19 percent

Question

Quizplus · Accepted Answer

The risk-free rate can be calculated using the Capital Asset Pricing Model (CAPM) formula, which is: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Given the firm's equity beta is 1.4, the expected market return is 15%, and assuming the firm's required return on equity is equal to its cost of equity (which is part of the WACC), we can rearrange the formula to solve for the risk-free rate. The expected return on equity can be approximated by the equity portion of the WACC, which is not directly given but can be implied to be necessary for the calculation. Without the direct calculation steps provided, the correct answer is derived through understanding the relationship between these variables and the CAPM formula.

A Firm Has 5,000,000 Shares of Common Stock Outstanding, Each