Question

In: Finance

A company has $107 million in outstanding bonds, and 10 million shares of stock currently trading...

A company has $107 million in outstanding bonds, and 10 million shares of stock currently trading at $40 per share.The bonds pay an annual coupon rate of 5% and is trading at par. The company's beta is 1.2, its tax rate is 40%, the risk-free rate is 3%, and the market risk premium is 4%. What is this firm's WACC?

Expert Solution

Firm’s Weighted Average Cost of Capital (WACC)

Market Value of each capital Structure

Market Value of Debt = $107 Million

Market Value of Equity = $400 Million [10 Million shares x $40 per share]

Total Market Value = $507 Million

Weights of each capital components

Weight of Debt = 0.2110 [$107 Million / $507 Million]

Weight of Equity = 0.7890 [$400 Million / $507 Million]

After-Tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

Here, the Bond is selling at Par, therefore, the Yield to maturity of the Bond is equals to the Annual Coupon rate of the Bond [5.00%]

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 5.00% x (1 – 0.40)

= 5.00% x 0.60

= 3.00%

Cost of Equity

As per Capital Asset Pricing Model [CAPM], the cost of equity is calculated by using the following equation

Cost of equity = Risk-free Rate + [Beta x Market Risk Premium]

= 3.00% + [1.20 x 4.00%]

= 3.00% + 4.80%

= 7.80%

Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [3.00% x 0.2110] + [7.80% x 0.7890]

= 0.63% + 6.16%

= 6.79%

“Hence, the Firm’s Weighted Average Cost of Capital (WACC) will be 6.79%”

jeff jeffy answered 9 months ago

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