Johnson's Diner has an adjusted WACC of 10.08%. The company has a capital structure consisting of 70% equity and 30% debt, a cost of equity of 12.00%, a before-tax cost of debt of 8.00%, and a tax rate of 30%
Johnson is considering expanding by building a new diner in a distant city and considers the project to be riskier than his current operation. He estimates his existing beta to be 1.0, the required return on the market portfolio to be 12.00%, the risk-free rate to be 3.00%, and the beta for the new project to be 1.40. Given this information, and assuming the cost of debt will not change if Johnson undertakes the new project, what adjusted WACC should he use in his decision-making?
A) 10.08%
B) 12.60%
C) 13.32%
D) 14.16%
Answer: B
Explanation: B) Re = E(ri) = rf + [E(rm) - rf] βi = 3.00% + [12.00% - 3.00%] × 1.4 = 15.60%.
WACC = × Rd × (1 - Tc) + × Re = 0.30 × (8.00%) × (1 - .30) + 0.70 × (15.60%) = 12.60%.
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