Question

Droz's Hiking Gear, Inc. 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. It has 7-year semiannual maturity bonds outstanding with a price of $767.03 that have a coupon rate of 7 percent. The firm is financed with $120,000,000 of common shares (market value) and $80,000,000 of debt. What is the after-tax weighted average cost of capital for Droz's, if it is subject to a 35 percent marginal tax rate? Round your final percentage answer to two decimal places.

Show in Excel pls thanks!

Answer 1

Equity Beta (b_e) = 1.5

Risk Free Rate (R_f) = 8%

Expected Market Return (R_m) = 14%

Using Capital Asset Pricing Model

K_e = R_f + b_{e *} (R_m - R_f)

K_e = 8% + 1.5 * (14% - 8%) = 17%

Now Calculation of Cost of Debt (K_d) [ Since not given in the question, lets assume face value of bond = $1,000)

Interest Paid = $1,000 * 7% = $70

Market Price of Bond = $767.03

K_d = $70 / $767.07 (Pre Tax)

K_d = 9.13% (Pre Tax)

K_d (Post Tax) = 9.13% * (1 - 0.35) = 5.93%

Now Calculation of Weighted Average Cost of Capital (After Tax)

WACC =(K_d * W_d) + (K_e + W_d)

W_d = 80,000,000/(80,000,000 + 120,000,000) = 0.4

W_e = 1 - W_d = 0.6

WACC = 5.93% * 0.4 + 17% * 0.6 = 12.57%