Question

Question 7 8 Marks
A company has 1,000,000 shares outstanding, and each share is currently worth R20. The shares have beta of 1.2. The company also has 10-year bonds outstanding with a par value of R10,000,000, a coupon rate of 6%, and yield-to-maturity of 7%. The yield on the bonds is currently 2 percentage points above the risk-free rate and 4 percentage points below the expected return on the overall market.
Required:
7.1. What is the company’s WACC if the corporate tax rate is 35%?

Answer 1

Market Value of Equity = No. of Shares Outstanding * Share Price = 1,000,000 * R20 = R20,000,000

To find the market value of debt, we need to put the following values in the financial calculator:

INPUT	10	7		6%*10,000,000 = 600,000	10,000,000
TVM	N	I/Y	PV	PMT	FV
OUTPUT			-9,297,641.85

So, the market value of debt = R9,297,641.85

Total Market Value = Market Value of Equity + Market Value of Debt

= R20,000,000 + R9,297,641.85 = R29,297,641.85

wD = Market Value of Debt / Total Market Value = R9,297,641.85 / R29,297,641.85 = 31.74%

wE = Market Value of Equity / Total Market Value = R20,000,000 / R29,297,641.85 = 68.26%

After-tax Cost of Debt = YTM * (1 - t) = 7% * (1 - 0.35) = 4.55%

Risk-free Rate = YTM - 2% = 7% - 2% = 5%

Expected Market Return = YTM + 4% = 7% + 4% = 11%

According to the CAPM,

Cost of Equity(kE) = Risk-free Rate + [beta * (Expected Market Return - Risk-free Rate)]

= 5% + [1.2 * (11% - 5%)] = 5% + 7.2% = 12.2%

WACC = [wD x After-tax kD] + [wE x kE]

= [0.3174 * 4.55%] + [0.6826 * 12.2%] = 1.44% + 8.33% = 9.77%