Question

**THERE ARE 2 PARTS TO THIS QUESTION, PLEASE ANSWER BOTH**

1. What is the WACC for the firm?

A	11.74%
B	12.55%
C	12.82%
D	13.35%
E	None of the above are within .25% of the correct answer.

Marley's Pipe Shops has found that its common equity capital shares have a beta equal to 1.5 while the risk-free return is 8 percent and the expected return on the market is 14 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt, and 35 percent is the marginal tax rate. The firm has semiannual bonds outstanding with nine years to maturity and are currently priced at $754.08. The bonds have a coupon rate of 7.25 percent. The face value on a bond is $1,000. The firm will invest $300,000 in a five-year project today that will produce annual cash flows of $80,000. What is the cost of equity for the firm? 15.50% 16.00% 17.00% 18.00%

Answer 1

Answer a)

Cost of Equity = Rf + beta (Rm - Rf)

= 8% + 1.5 * (14% - 8%)

= 8% + 9%

= 17%

Option 3 is correct.

Answer b)

YTM Calculation

Current Price = 754.08

Coupon 7.25% * 1000 = 72.5

Maturity = 9 years

Let's assume the YTM be 11%

Value of Bond = $\small Coupon *\frac{1-\frac{1}{(1+r)^{n}}}{r} + \frac{Maturity Value}{(1+r)^{n}}$

= $\small 72.5 *\frac{1-\frac{1}{(1+0.11)^{9}}}{0.11} + \frac{1000}{(1+0.11)^{9}}$

= 792.360717525

Now,

Let's assume the YTM be 12%

Value of Bond = $\small Coupon *\frac{1-\frac{1}{(1+r)^{n}}}{r} + \frac{Maturity Value}{(1+r)^{n}}$

= $\small 72.5 *\frac{1-\frac{1}{(1+0.12)^{9}}}{0.12} + \frac{1000}{(1+0.12)^{9}}$

= 746.908133488

YTM = $\small Lower Rate + (\frac{Surplus}{Surplus + deficit}) * (Higher Rate - Lower rate)$

= 9% + ((792.360717525 - 754.08) / (792.360717525 - 754.08) + (754.08 - 746.908133488)) * (12-11)

=11.84%

Value of Equity = 120m

Value of Debt = 80 mn

Total Capital = 200 mn

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

= 17% * 120 / 200 + 11.84%* (1-0.35) * 80/200

= 13.35%

option D is correct.