Question

Epson has one bond outstanding with a yield to maturity of 5% and a coupon rate of 8%. The company has no preferred stock. Epson's beta is 0.9, the risk-free rate is 0.6% and the expected market risk premium is 6%.

Epson has a target debt/equity ratio of 0.7 and a marginal tax rate of 34%.

1. What is Epson's (pre-tax) cost of debt?

2. What is Epson's cost of equity?

3. What is Epson's capital structure weight for equity, i.e., the fraction of long-term capital provided by equity?

4. What is Epson's weighted average cost of capital?

Answer 1

1. The coupon rate gives the amount of coupon to be received periodically as coupon rate*Face value. But the pre tax cost of debt is given by the yield to maturity or YTM. Thus, pre tax cost of debt is YTM = 5%.

2. According to Capital asset pricing model, CAPM, the cost of equity is given as under:

Cost of equity = Risk free rate + Beta*Market risk premium

Cost of equity = 0.6+0.9*6 = 6%

3. Target debt/equity ratio = 0.7. Thus, for 0.7 debt, 1 equity is present in the capital structure. So, the fraction of long term capital provided by equity = Equity/(Equity+Debt) = 1/(1+0.7) = 1/1.7 = 0.5882

4. Weighted average cost of capital, WACC = %debt*(cost of debt)*(1-tax) + %equity*(cost of equity)

% equity in the capital structure = 0.5882

% debt in the capital structure = 1-0.5882 = 0.4118

WACC = 0.4118*5*(1-0.34) + 0.5882*6

= 1.3589+3.5292= 4.888%

Thus, weighted average cost of capital is 4.89%

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