Engineering Economy

Explain in a 1-page typed essay why there are differences between these two companies with respect to their beta values, debt to equity ratios, and average cost of debt.

As the calculations show, the values of the cost of equity, and the weighted average cost of capital differ between the semiconductor and the electric utility company. The differences in the values arise from the fact that these two companies perform in different industries, and therefore use different financial and capital structures, that, in turn, result in different equity beta values, debt to equity ratios, and average costs of debt. These values are used in order to calculate their respective cost of equity and the weighted average cost of capital, and such variance in values will naturally lead to different calculation results. To understand how different calculation results arise, we first need to understand the following formulae:

R S = R F + β(R M −R F)

WACC = λ(1−t)K D + (1−λ)K E

The question had same values for Rm, and the market risk premium for both semiconductor and electric utility company. Therefore, we only need to observe how the beta values, debt to equity ratios, and average cost of debt affect the cost of equity and the weighted average cost of capital.

For the cost of equity, the equity beta value becomes the determinant variable when all other inputs are consistent. Since the cost of equity has a proportional relationship with the equity beta value, the company with higher equity beta value will have a higher cost of equity. Generally, the beta values measure the correlated volatility, and higher beta value would indicate that the company is subject to higher degree of volatility. Since the electric utility is more of a necessity than is the semiconductor company, the former would face less volatility, hence a lower equity beta value. This results in a lower equity cost of 9%, compared to 17.5% of the semiconductor company.

The weighted average cost of capital...