Problem: Smoltz Enterprises is currently involved in its yearly review of the firm's cost of capital. Historically, the firm has relied on CAPM to estimate its cost of equity capital. The firm estimates that its equity beta is 1.25, and the current yield on long-term U.S. Treasury bonds is 4.28%. The firm's CFO is currently in a debate with one of the firm's advisors at its investment bank about the level of the equity risk premium. Historically, Smoltz has employed 7% to approximate the equity risk premium. However, the investment banker argues that this premium has shrunk dramatically in recent years and is more likely to be in the 3% to 4% range.
a. Estimate Smoltz’s cost of equity capital using a market risk premium of 3.5%.
b. Smoltz’s capital structure is consisted of 75% equity (which is based on current market prices) and 25% debt on which the firm pays a yield of 5.125% before taxes at 25%.
c. What is the firm's WACC under each of the two assumptions concerning the market risk premium?