Question

ABC Inc. has 10,000 shares of common stock and 3,000 units of debt. Each unit of debt has a face value of $100, 6% coupon rate, and 10 years to maturity. The common stock has a standard deviation of return of 30% and a correlation coefficient with S&P 500 return of 0.75. The S&P500 has a return of 12.5% and a standard deviation of return of 20%. The T-bill rate is 3.5%. The debt has a default risk premium of 2% and a maturity risk premium of 1%. The stockholders are expected to receive a dividend of $2 five years hence and a stock price of $105 five years hence. ABC Inc. has a corporate tax rate of 30%.

1. Determine the cost of common stock, and the cost of debt.
2. What is the capital structure of ABC? (How much of the capital is raised by issuing common stock and debt, respectively?)
3. Determine the weighted average cost of capital.
4. If return on an investment is 10%, is the investment acceptable? Explain.

Answer 1

Cost of common stock = risk free retrun + beta * ( market return - risk free return = 3.5% + 0.75 ( 12.5% - 3.5% )

= 3.5% + 6.75%

= 10.25%

Cost of debt = coupon rate ( 1- tax rate )

= 6% * ( 1 - 0.3)

= 4.2%

Weighted average cost of capital = ke * Pe + Kd * Pd

= 10.25% * 1000000/1300000 + 4.2% * 300000/1300000

= 8.854%

Where ke = cost of equity

Pe = Proportion of equity

Kd = cost of debt

Pd = proportion of debt

If return of investment is 10% then the same is higher than wacc of 8.854% therefore investments are viable.