The current capital structure of Amgel Manufacturing Company

The current capital structure of Amgel Manufacturing Company has 30% debt and 70% equity (based on market values). While the beta Amgel equity (based on your current level of debt financing) is 1.20, its debt is beta 0.29. In addition, the rate of risk free rate is currently 4.5% on government bonds in the long term. The Amgel investment banker advised the firm in stating that estimates the market risk premium is 5.25%.

1. What is your estimate of the cost of equity for Amgel (based on the CAPM)?

2. If the marginal tax rate is 35% Angel, what is the weighted average cost of capital (WACC) of that organization?

3. Amgel provides significantly expand operations. The investment banker believes that Amgel firm may borrow up to 40% of the necessary funds and maintain its current credit rating and the cost of borrowing. WACC estimate for this project

Solution

1.

the overall company beta = 0.3 * 0.29 + 0.7 * 1.2 = 0.927

K_e = R_f + beta * risk premium= 4.5% + 0.927 * 5.25% = 9.367%

2. since the rate of debt is not given it is assumed that the debt has been taken at market return = 5.25% + 4.5% = 9.75%

WACC = 0.3 * 9.75 % * (1-0.35) + 0.7 * 9.367% = 8.4581%

3. Because the company can borrow upto 40% of its requirement so the capital structure will change

WACC = 0.4 * 9.75 % * (1-0.35) + 0.6 * 9.367% = 8.1552%