Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.2. The company has a target debt–equity ratio of .3. The expected return on the market portfolio is 11 percent, and Treasury bills currently yield 3.7 percent. The company has one bond issue outstanding that matures in 20 years and has a coupon rate of 8.4 percent. The bond currently sells for $1,150. The corporate tax rate is 35 percent.

  

a.	What is the company’s cost of debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Cost of debt

%

  

b.	What is the company’s cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Cost of debt

%

  

c.	What is the company’s weighted average cost of capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

WACC

%

Answer 1

Cost of debt is the after tax YTM of the bond

Step 1 : Calculate the bond YTM using the following inputs:

Future value = $ 1000 , Present value = $1150, N = 20, Coupon = 8.4 *1000 = 84, I =??

YTM = 6.99%

Cost of debt = YTM * (1 - tax rate)

= 6.99% * (1 -35%)

= 4.54%

Cost of equity can be calculated with the help of CAPM formula which states:

Cost of equity = Risk free rate + Beta * (Market return - Risk free rate)

= 3.7% + 1.2 * (11% - 3.7%)

= 12.46%

WACC is the weighted average cost of capital. We know the cost of debt and cost of equity

Weight of equity = Equity / Total Capital

We know that : Debt / Equity = 0.3

So Debt = 0.3 * Equity

Total capital = Debt + Equity

= 0.3 * Equity + Equity

Total capital = 1.3 * Equity

So weight of equity = Equity / (1.3 * Equity) = 1 / 1.3 = 76.92%

Weight of debt = 100% - weight of equity = 100% - 76.92% = 23.08%

WACC = weight of debt * cost of debt + weight of equity * cost of equity

= 23.08% * 4.54% + 76.92% * 12.46%

= 10.63%