Duvall and his advisers have decided to use an income approach to value Able Manufacturing.

Because of its years of operating successfully and its owner’s conservative nature, Able operated with little debt. Smith explored various sources of debt financing to operate Able with a lower overall cost of capital. Analysis of public companies in Able’s industry indicated several guideline public companies for possible use in estimating a discount rate for Able. Duvall and his advisers agreed on the following estimates:

• Risk free rate: Estimated at 4.8 percent.
• Equity risk premium: The parties agreed that a 5 percent equity risk premium was appropriate.²¹

• Beta: A beta of 1.1 was estimated based on publicly traded companies in the same industry.

• Small stock premium: The smaller size and less diversified operations suggest greater risk for Able relative to public companies. A small stock premium of 3 percent was included in the equity return calculation for these expected risks.²²

• Company-specific risk premium: Assessment of Able indicated that beyond Smith’s key role at the company, no other unusual elements created additional risk. A 1 percent company-specific risk adjustment was included.23

• Industry risk premium (build-up method only): The industry risk premium was 0 percent because no industry-related factors were viewed as materially affecting the overall required return on equity estimate.
• Pretax cost of debt: Estimated at 7.5 percent.
• Ratio of debt to total capital for public companies in the same industry: Estimated at 20 percent.
• Optimal ratio of debt to total capital: The ratio was estimated at 10 percent based on discussions with various sources of financing. Able would not be able to achieve the industry capital structure based on its smaller size compared to public companies and the greater risk of its operations as a standalone company.
• Actual ratio of debt to total capital: For Able, the actual ratio was 2 percent.
• Combined corporate tax rate: Estimated at 40 percent.

Based only on the information given, address the following:

i. Calculate the required return on equity for Able using the CAPM.
ii. Calculate the required return on equity for Able using the expanded CAPM.
iii. Calculate the required return on equity for Able using the build-up method.
iv. Discuss the selection of the capital structure weights to use in determining the weighted average cost of capital for Able.
v. Calculate the WACC for Able using the current capital structure and a 14 percent cost of equity.
vi. Calculate the WACC for Able based on the optimal capital structure for Able and a 14 percent cost of equity.