Question

Please show full work if possible, would like to be able to understand the problem and solution.

1. Lion Inc. recently hire you as a consultant to estimate the company’s WACC. You have

obtained the following information.

(1) The firm’s noncallable bonds mature in 20 years, have an 8% annual coupon, a par

value of $1,000, and a market price of $1,050.

(2) The company’s tax rate is 40%.

(3) The risk-free rate is 4.50% and the market risk premium is 5.50%. The stock has a

beta of 1.20.

(4) The target capital structure consists of 35% debt and the remainder is common

stock.

(5) The firm uses the CAPM to estimate the cost of equity, and it does not expect to

issue any new common stock.

Please identify the company’s WACC

A. 7.16%

B. 7.54%

C. 7.93%

D. 8.35%

E. 8.79%

Answer 1

Weight of equity = 1-D/A

Weight of equity = 1-0.35

W(E)=0.65

Weight of debt = D/A

Weight of debt = 0.35

W(D)=0.35

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (Market risk premium)

Cost of equity% = 4.5 + 1.2 * (5.5)

Cost of equity% = 11.1

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =20

1050 =∑ [(8*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^20

k=1

YTM = 7.5091959827

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 7.5091959827*(1-0.4)

= 4.50551758962

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=4.51*0.35+11.1*0.65

WACC =8.79%