Question

2. [Ch 10] You are the CFO of a company, and you need to analyze a new product line. The company has 8% coupon-bonds outstanding with $1000 face value that trade at par. Their stock, which trades at $25 on the NASDAQ has a beta of 1.25 and just paid a dividend of $3.00 and the dividends are expected to grow at 5% annually, indefinitely. The company has a debt-to-equity ratio of 3 and pays taxes at the 35% annual tax rate. If the expected return on the market is 10% and treasury bills pay 4%, what is the weighted average cost of capital for FIN317 Corp? (assume no preferred stock) Please show 4 decimals, i.e. 0.xxxx or x.xx%. HINT: Use the debt-to-equity-ratio to find the weights; wd = DEBT/(Total Assets) and WS = EQUITY/(Total Assets). Use the technique (formula) we used back in Chapter 3.

Answer 1

Bond trade at Par, thus,

Cost of Debt = Coupon rate = 8%

Tax rate = 35%

Post-tax cost of Debt (kd) = 0.08*(1-0.35) = 0.052

Beta of stock = 1.25

Market return = 10%

T-bills rate = 4%

Cost of Equity (ke) = 0.04*1.25*(0.1-0.04) = 0.115

Debt to equity ratio = 3

Weight of Debt (wd) = 3/4 = 0.75

Weight of equity (we) = 0.25

$WACC = wd*kd+we*ke$

$WACC = 0.75*0.052+0.25*0.115$

$WACC = 0.06775$

$\bg_green \large WACC = 6.76\%$

Please note: In above solution, CAPM model used to determine the cost of equity because CAPM model gives minimum required return by equity investors.

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.