Question

Angel Inc. recently hired 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 8.00% annual coupon, a par value of $1,000, and a market price of $1,225.00. (2) The company’s tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock’s beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? Do not round your intermediate calculations.

		8.48%
		10.01%
		7.80%
		6.79%
		7.63%

Answer 1

The cost of debt is calculated by computing the yield to maturity.

Information provided:

Par value= future value= $1,000

Time= 20 years

Current price= present value= $1,225

Coupon rate= 8%

Coupon payment= 0.08*1,000= $80

Enter the below in a financial calculator to compute the yield to maturity:

FV= 1,000

PV= -1,225

PMT= 80

N= 20

Press the CPT key and I/Y to compute the yield to maturity.

The value obtained is 6.03.

Therefore, the yield to maturity is 6.03%.

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

Information provided:

Risk free rate= 4.50%

Market risk premium= 5.50%

Beta= 1.20

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 4.50% + 1.20*5.50%

     = 4.50% + 6.60%

     = 11.10%.

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t) +We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.35*6.03%*(1 – 0.40) + 0.65*11.10%

            = 0.35*3.6180% + 0.65*11.10%

            = 1.2663% + 7.2150%

            = 8.4813%    8.48%.

Hence, the answer is option a.

In case of any query, kindly comment on the solution.