Question

Suppose that ABC Corp. has an equity beta of 1.5. Current risk-free rates are 5% and the expected return on the market portfolio is 15%. ABC Corp has a market value debt-to-equity ratio of 0.5, debt that is rated AA, and faces a 21% tax rate. Assuming that the credit spread on AA debt is 2%, compute ABC Corps WACC? Enter your answer as a percent without the % sign. Round to two decimals.

Answer 1

Debt to equity ratio is 0.5      
Debt /Equity = 0.5      
It means if Equity is 1, Debt is 0.5      
      
Weight of debt = Debt/(Debt + Equity)      
"0.5/(0.5+1) =
"   0.3333333333  
Weight of equity = Equity/(Debt + equity)      
1/(0.5 + 1)=   0.6666666667  
Cost of Equity = Risk free rate +(Beta*(Market Expected Return-Risk free rate)      
5% +(1.5*(15%-5%))=   20.00%  
Credit spread of AA rated bond is 2%. it means pretax cost of debt is Risk free+spread= 5%+2%=   7%  
after Cost of debt = Pretax cost * (1-tax rate)      
7%*(1-21%)=   5.530%  
      
WACC = (weight of debt * cost of debt) + (weight of equity * cost of equity)      
(0.3333333333*5.53%) + (0.666666667 * 20%)      
15.18%      
      
So, WACC is 15.18%