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Based on the information provided in the case, estimate the cost of debt and the cost of equity for
Dragon Air.
After-Tax Cost of Debt
The After-tax Cost of Debt for Dragon Air is estimated using the best lending rate in Exhibit 2 for Cathay
Pacific Airways as Bevis mentioned that the firm should use Cathay Pacific as a proxy firm. In the Exhibit
2, the most recent best lending rate is 7.42% on Jan 2006. I suggest using that lending rate for as the cost
of debt for Dragon Air
Since the cost of debt in the WACC formula after tax as the interest expense is tax deductible, we need to
consider the tax effect using the corporate tax rate of 17.5% as Bevis suggested in the case:
After-tax Cost of Debt = 7.42% x (1 17.5%) = 6.12%
Cost of equity
The cost of equity is estimated using the CAPM formula: Re = f + RB
f Risk-free rate
The risk-free rate is estimated using the long-term government bond with a time horizon similar to the
length of the investment. In exhibit 2, we have the 1-yr Hong Kong Exchange Fund Bill and 10-Yr Exchange
Fund Note. I suggest using the most recent 10-yr Exchange Fund Note of 4.18% as the risk-free rate.
The possible range for Dragon Airs WACC is from 6.3% to 6.32% which depend on the change in the
weight of Debt and Equity. As the cost of equity is slightly higher than the cost of debt, the increase in
weight of equity ( as in 2004) will lead to an increase in WACC.