Question

Upton Umbrellas has a cost of equity of 11.9 percent, the YTM on the company's bonds is 6.4 percent, and the tax rate is 40 percent. The company's bonds sell for 103.5 percent of par. The debt has a book value of $417,000 and total assets have a book value of $955,000. If the market-to-book ratio is 2.83 times, what is the company's WACC?

Multiple Choice: 8.31% 5.62% 10.12% 9.84% 8.44%

Answer 1

Market Value of Debt

Market Value of Debt = Book value of debt x 103.50%

= $417,000 x 103.50%

= $431,595

Market Value of Equity

Market Value of Equity = Book Value of Equity x Market-to-book ratio

= [Total book value of asset – Book value of Debt] x Market-to-book ratio

= [$955,000 - $417,000] x 2.83 Times

= $538,000 x 2.83 Times

Total Market Value

Total Market Value = Market value of debt + Market value of Equity

= $431,595 + $1,522,540

= $1,954,135

After Tax Cost of Debt

After Tax Cost of Debt = Yield to maturity of the Bond x (1 – Tax rate)

= 6.40% x (1 – 0.40)

= 6.40% x 0.60

3.84%

Cost of Equity = 11.90%

Weight of Debt = 0.2209 [$431,595 / $1,954,135]

Weight of Equity = 0.7791 [$1,522,540 / $1,954,135]

Weighted Average Cost of Capital (WACC)

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [3.84% x 0.2209] + [11.90% x 0.7791]

= 0.85% + 9.27%

= 10.12%

“Hence, the Company’s Weighted Average Cost of Capital (WACC) will be 10.12%”