Suppose the total book value of a firm is $6 million (that is, Debt + Equity = $6m), while the total book value of its debt alone is $4 million. The CFO estimates that the beta of the stock is currently 1.2 and that the expected risk premium on the market is 10 percent (i.e., RPm = (rmkt - rrf ) = 10%). The U.S. Treasury note rate (rrf) is 4 percent.
a. What is the required rate of return (rs) on this firm's common stock?
b. Estimate the weighted average cost of capital (WACC) assumingthe cost of debt is 14% (rd = 14%) and a tax rate of 40 percent.