Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of .95. The company has a target debt–equity ratio of .40. The expected return on the market portfolio is 11 percent, and Treasury bills currently yield 3.5 percent. The company has one bond issue outstanding that matures in 15 years and has a coupon rate of 6.5 percent. The bond currently sells for $1,080. The corporate tax rate is 21 percent.

1. What is the company’s cost of debt?
2. What is the company’s cost of equity?
3. What is the company’s weighted average cost of capital?

Answer 1

1).

Face Value = $1,000

Annual Coupon Payment = $1000*6.5%

= $65

No of years to maturity(n) = 15

Current selling Price = $1080

Calculating YTM using Trial and error method:-

Taking YTM lower than coupon rate as 6%

Price = $631.293 + $417.27

Price = $1048.56

Now, taking YTM as 5%

Price = $674.6805 + $481.02

Price = $1155.70

Now, Calculaying YTM:-

107.14

YTM = 5.70%

Company's Cost of Debt = Yield to maturity*(1-Tax Rate)

= 5.70*(1-0.21)

= 4.50%

b). Calculating Levered Beta from all equity beta:-

Levered Beta = Unlevered Beta*[1+(1-Tax rate)*Debt/Equity]

= 0.95*[1+(1-0.21)*0.40]

= 1.2502

As per CAPM,

R_f = Risk free Return = 3.5%                                                    

R_m = Market return = 11%

Beta = 1.2502

Required rate of Return = 3.5% + 1.2502(11%-3.5%)

= 12.8765%

So, Cost of equity = 12.8765%

c).

So, Debt portion is 0.40

& Equity is 1

calculating WACC:-

WACC= (Weight of Debt)(Cost of Debt) + (Weight of Equity)(Cost of Equity)

WACC = [0.40/(1+0.40)](4.50%) + [1/(1+0.40)](12.8765%)

WACC = 1.2857% + 9.1975%

WACC = 10.48%

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