(1) The firm's existing noncallable bonds which mature in 40 years, have an 5.00% annual coupon, a par value of $1,000, and a market price of $950. You have done some research and estimate the cost of issuing additional debt would cost you similarly to the existing bonds.
(2) The company's current tax rate is 40%, but the tax rate is estimated to go up to 35% very soon.
(3) The projected future risk-free rate is 2.50%. The market return is predicted to be 7.50%. The stock's historical beta is 1.52, as some uncertainty resolved, it’s expected to decrease to 1.20.
(4) The target capital structure consists of 25% debt and the balance is common equity. While based on the book value, debt accounts for 10% and equity accounts for 90%.
The firm uses CAPM to estimate the cost of common stock, and it does not expect to issue any new shares.
What is its WACC given all above information?
Working 1: Calculation of expected cost of common stock using CAPM :
Cost of stock = Rf + Beta (Rm - Rf)
Here,
Rf (Risk free return) = 2.50% or 0.025
Rm (Market rate) = 7.50% or 0.075
Beta (Expected) = 1.20
Now, put the values into the formula,
Cost of stock = 0.025 + 1.20 * (0.075 - 0.025)
Cost of stock = 0.025 + 0.06
Cost of stock = 0.085 or 8.50%
Working 2 : Calculation of Cost of debt :
Here cost of debt is equals to YTM (yield to maturity) of bond.
YTM of bond= (Copoun + ((P - M) /n)) / ((P + M)/2)
P (Par value) = $1000
M (Market price) = $950
n (years) = 40 years
Copoun = Par value * rate = $1000 * 5% = $50
Now, put the values into formula,
YTM = ($50 + (($1000 - $950)/40)) / (($1000 + $950) / 2)
YTM = ($50 + $1.25) / $975
YTM = 0.0526 or 5.26%
So, cost of debt = 5.26% (Cost of debt = YTM)
Working 3 : Calculation of WACC (using target capital structure)
Cost of equity = 8.50% or 0.085
Cost of debt = 5.26% or 0.0526
Weight of debt = 25% or 0.25
Weight of equity = 75% or 0.75 (100 - 25 ie debt)
Tax rate (Estimated) = 35% or 0.35
Now,
WACC = (Weight of debt * Cost of debt * (1 - tax rate)) + (Weight of equity * Cost of equity)
WACC = (0.25 * 0.0526 *(1 - 0.35)) + (0.75 * 0.085)
WACC = (0.25 * 0.0342) + 0.0638
WACC = 0.0086 + 0.0638
WACC (as per target capital structure) = 0.0724 or 7.24%
Working 4 : WACC calculation as per book value:
Cost of equity = 8.50 % or 0.085
Cost of debt = 5.26% or 0.0526
Weight of debt = 10% or 0.10
Weight of equity = 90% or 0.90
Tax rate = 35% or 0.35
Now,
WACC = (Weight of debt * Cost of debt * (1 - tax rate)) + (Weight of equity * Cost of equity)
WACC = (0.10 * 0.0526 *(1 - 0.35)) + (0.90 * 0.085)
WACC = (0.10 * 0.0342) + 0.0765
WACC = 0.0034 + 0.0765
WACC(as per book value) = 0.0799 or 7.99%
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