Problem Solving: Given the following information, what is the WACC?
Commom Stock: 1 million shares outstanding, $40 per share, $1 par value, beta = 1.3; 10,000 bonds outstanding, $1,000 face value each, 8% annual coupon, 22 years to maturity, market price = $1,101.23 per bond
Market risk Premium = 8.6 %, risk-free rate = 5%, marginal tax rate = 35%
Cost of equity:
Information provided:
Risk free rate= 5%
Market risk premium= 8.6%
Beta= 1.3
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:
Ke=Rf+b[E(Rm)-Rf]
Where:
Rf=risk-free rate of return which is the yield on default free debt like treasury notes
Rm=expected rate of return on the market.
b= stock’s beta
Ke= 5% + 1.3*(8.6% - 5%)
= 5% + 4.68
= 9.68%.
Cost of debt:
Information provided:
Face value= future value= $1,000
Coupon rate= 8%
Coupon payment= 0.08*1,000= 480
Time= 22 years
Market price= present value= $1101.23
The cost of debt is calculated by computing the yield to maturity.
The yield to maturity is calculated by entering the below in a financial calculator:
FV= 1,000
PV= -1101.23
N= 22
PMT= 80
Press the CPT key and I/Y to compute the yield to maturity.
The value obtained is 7.0788.
Therefore, the before tax cost of debt is 7.08%.
Debt in the capital structure= 10,000*$1101.23= $11,012,300
Equity in the capital structure= 1,000,000*440= $40,000,000
Total firm capital= $11,012,300 + $40,000,000= $51,012,300.
Weight of debt in the firm’s capital = $11,012,300/ $51,012,300
= 0.2159*100
= 21.59%
Weight of equity in the firm’s capital= $40,000,000/ $51,012,300
= 0.7841*100
= 78.41%
The weighted average cost of capital is calculated using the below formula:
WACC=Wd*Kd(1-t) +We*Ke
where:
Wd= Percentage of debt in the capital structure.
Kd= The before tax cost of debt
We=Percentage of common stock in the capital structure
Ke= The cost of common stock
T= Tax rate
WACC= 0.2159*7.08%*(1 – 0.35) + 0.7841*9.68%
= 0.9936% + 7.5901%
= 8.5837% 8.58%.
In case of any query, kindly comment on the solution
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