Question

The Stetson Group, a leading producer of custom women's accessories, has hired you to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below.

Assets
Current assets	$7,780,000
Net plant, property, and equipment	131,230,000
Total assets	$139,010,000
Liabilities and Equity
Accounts payable	$10,003,000
Accruals	9,007,000
Current liabilities	$19,010,000
Long-term debt (30,000 bonds, $1,000 par value)	30,000,000
Total liabilities	$49,010,000
Common stock (10,000,000 shares)	40,000,000
Retained earnings	50,000,000
Total shareholders' equity	90,000,000
Total liabilities and shareholders' equity	$139,010,000

The stock is currently selling for $20.25 per share, and its non-callable $1,000 par value, 20-year, 8.35% bonds with semiannual payments are selling for $975.00. The beta is 1.25, the yield on a 6-month Treasury bill is 2.84%, and the yield on a 20-year Treasury bond is 4.52%. The required return on the stock market is 10.50%, but the market has had an average annual return of 13.25% during the past 5 years. The firm's tax rate is 40%.

Refer to the data for the Stetson Group above. What is the best estimate of the firm's WACC?

Answer 1

Market value of debt (MVd) = bond price*number of bonds = 975*30,000 = 29,250,000

Market value of equity (MVe) = share price*number of shares = 20.25*10,000,000 = 202,500,000

Total capital (V) = MVd + MVe =  29,250,000 + 202,500,000 = 231,750,000

Weight of debt (wd) = MVd/V = 29,250,000/202,500,000 = 12.62%

Weight of equity (we) = MVe/V = 202,500,000/202,500,000 = 87.38%

Cost of equity (using CAPM) (ke) = risk-free rate + beta*(market return - risk-free rate)

= 4.52% + 1.25*(13.25%-4.52%) = 15.43%

Note: Risk-free rate of a long term T-bill is preferable. For market returns, it is preferable to take actual returns rather than required ones.

Cost of debt: FV = 1,000; PV = -975; PMT (semi-annual coupon payment) = coupon rate*par value/2 = 8.35%*1,000/2 = 41.75; N = 20*2 = 40, CPT rate. rate = 4.31%

Annual YTM = 4.31%*2 = 8.61%

After-tax cost of debt (kd) = Annual YTM*(1-Tax rate) = 8.61%*(1-40%) = 5.17%

WACC = (wd*kd) + (we*ke)

= (12.62%*5.17%) + (87.38%*15.43%) = 14.14%