Diversified plc is trying to introduce an improved method of assessing investment projects using discounted cash flow techniques. For this it has to obtain a cost of capital to use as a discount rate. The finance department has assembled the following information:
- The company has an equity beta of 1.50, which may be taken as the appropriate adjustment to the average risk premium. The yield on risk-free government securities is 7 per cent and the historic premium above the risk-free rate is estimated at 5 per cent for shares.
- The market value of the firm's equity is twice the value of its debt.
- The cost of borrowed money to the company is estimated at 12 per cent (before tax shield benefits).
- Corporation tax is 30 per cent.
Assume: No inflation.
Required
Estimate the equity cost of capital using the capital asset pricing model (CAPM). Create an estimate of the weighted average cost of capital (WACC).