Question

At 2018 ABI Construction has a face debt value of 27.24M trading at 89% with a pre-tax weighted cost of 4.27%. ABI common equity for the year was valued at 110.8M and preferred equity for 12.2 M the preferred equity rate was calculated to be 8.46%. However, the common equity was to be calculated using CAPM approach, with a 3% risk free rate and a 7% market risk premium rate, assuming a 1.64 beta. If the tax rate is 41% what is the firms WACC?

Answer 1

Cost of equity is the required rate of return on the company’s common stock. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

The formula for calculating the Cost of equity 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= Beta of the company

Ke= 3% + 1.1.64*7%

= 3% + 11.48%

= 14.48%

Market value of debt = 89%*$27.24 million

= $24,243,600

Market value of the firm = $24,243,600 + $12,200,000 + $110,800,000

= $147,243,600

Weight of debt = $24,243,600/ $147,243,600

= 0.1646

Weight of preferred stock = $12,200,000 / $147,243,600

= 0.0829

Weight of equity = $110,800,000 / $147,243,600

= 0.7525

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

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

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.1646*4.27%*(1 - 0.41) + 0.0829*8.46% + 0.7525*14.48%

= 0.1646*2.5193% + 0.0829*8.46% + 0.7525*14.48%

= 0.4147% + 0.7013% + 10.8962%

= 12.0122% 12.01%.