Question

The Sweet Dreams Candy Company has hired you to estimate its Weighted Average Cost of Capital.

Management has provided you with the following information:

Current Debt: The company has 180,000 bonds, par value $1000, selling at 95% of par. The bonds have a coupon rate of 3% and 15 years to maturity.

Common Stock: The company has 3,750,000 shares of common selling for $62 per share. The book value per share is $23. The stock has a beta of 1.2

Additional information: The company has a tax rate of .35, the market risk premium is 7.5%, and the risk-free interest rate is 2%.

Answer 1

Solution:
	WACC =7.28%
Working Notes:
	Common stock =3,750,000 shares
	Bond   = Face value = No of bonds x par value = 180,000 x $1,000 = $180,000,000
	Current market share price = $62
	Bond is selling at 95% of par
	Total Market value of common stock (E) = No. of Common stock shares x Market price per share
	Total Market value of common stock (E) = 3,750,000 shares x $62
	Total Market value of common stock (E) = $232,500,000
	Total Market value of Bond (D)= Total Face value of bond x % of par at which bond is selling in market
	Total Market value of Bond   (D) = $180,000,000x 95%
	Total Market value of Bond   (D)= $171,000,000
	the firm’s market value company capital structure (V) = E + D = $232,500,000 + $171,000,000
	the firm’s market value company capital structure (V) = E + D = $403,500,000
	Debt (Bond) weight in capital structure = D/V = Mkt. Value of Bond / Total Mkt. Value of Company
	Debt (Bond) weight in capital structure = $171,000,000/$403,500,000
	Debt (Bond) weight in capital structure = 0.423791822
	Common stock weight in capital structure = E/V = Mkt. Value of common stock / Total Mkt. Value of Company
	Common stock weight in capital structure = E/V = $232,500,000 /$403,500,000
	Common stock weight in capital structure = E/V =0.576208178
Cost of Equity (Ke)
	As per CAPM   required rate return on stock (Ke) = rf + (rm-rf) x B
	Ke= Cost of Equity (Ke) =??
	B= Beta of the stock = 1.2
	rf= risk free rate = 2%
	(rm -rf)= market risk premium = 7.5%
	Ke= rf + (rm-rf) x B
	Ke= 2% + 7.5% x 1.2
	Ke= 2% + 9%
	Ke= 11%
cost of debt pre tax (kd)
Notes:	Since question have just given coupon rate 3% , not indicating whether bond is paying semi annual or annual , it is general assumption the is paying semi-annual.
	As the bond is paying coupon semi annually , its Ytm can be calculated by Excel or financial calculator
	First we get the semi annual YTM
	No. of period = years to maturity x no. of coupon in a year = 15 x 2 =nper = N = 30
	Face value of bond = FV= $1,000
	Price of the bond = PV = -$950         [1000 x 95% = $950]
	Semi-annual Coupon amount = PMT = coupon rate x face value/2 = 3% x $1,000 /2= $15
	For calculation YTM by excel
	type above data in below format
	=RATE(N,pmt,PV,FV)
	=RATE(30,15,-950,1000)
	1.7145839%
	=1.7145839%
	The YTM calculated is semi annual
	YTM annual = Semi annual YTM x 2
	YTM annual = 1.7145839% x 2
	YTM annual bond = 3.429167876%
	After Tax cost of debt (kd)= YTM of bond x (1 - tax rate) = 3.429167876% x (1-0.35)
	After Tax cost of debt (kd)=2.228959119%
WACC
	WACC = (E/V x Ke) + (D/V x After tax Kd)
	= (0.576208178 x 11% + 0.423791822 x 2.228959119%)
	0.07282905
	=0.0728
	=7.28%
	WACC =7.28%
Where
	Debt (Bond) weight in capital structure = 0.423791822
	Common stock weight in capital structure = E/V =0.576208178
	Ke= 11%
	After Tax cost of debt (kd)=2.228959119%
Please feel free to ask if anything about above solution in comment section of the question.