Question

Foods’ (BF) balance sheet shows a total of $25 million long-term debt with a coupon rate of 8.50%. The yield to maturity on this debt is 8.00%, and the debt has a total current market value of $27 million. The balance sheet also shows that the company has 10 million shares of stock, and the stock has a book value per share of $5.00. The current stock price is $20.00 per share, and stockholders' required rate of return, r_s, is 12.25%. The company recently decided that its target capital structure should have 35% debt, with the balance being common equity. The tax rate is 40%. Calculate WACCs based on book, market, and target capital structures, and then find the sum of these three WACCs.

You must show your work step-by-step and write 4 lines for each problem to explain your approach of finding the solution.

Answer 1

		CALCULATION OF WACC BASED ON BOOK VALUE
	a	Book Value of Debt	$25,000,000
	b	Book Value of Equity=10 million *$5.00	$50,000,000
	c=a+b	Book Value of Total Capital	$75,000,000
	Wd=a/c	Weight of Debt in the capital structure	0.333333333
	We=b/c	Weight of Equity in the capital structure	0.666666667
		Weighted Average Cost of Capital (WACC)
		WACC=Wd*Cd+We*Ce
		Wd=Weight of Debt in the total capital
		We=Weight of Equity in the total capital
		Cd=Cost of Debt
		Ce=Cost of Equity
		AFTER TAX COSTS:
		Yield to Maturity	8.00%
		Tax Rate	40.00%
	Cd	After Tax Cost of Debt=8*(1-Tax Rate)=8*(1-0.40)=	4.80%
	Ce	Cost of Equity =Required Return	12.25%
		After Tax Weighted average Cost of Capital:
		WACC=Wd*Cd+We*Ce=	9.77%
		WACC BASED ON BOOK VALUE	9.77%
		CALCULATION OF WACC BASED ON MARKET VALUE
	a	Market Value of Debt	$27,000,000
	b	Market Value of Equity=10 million *$20.00	$200,000,000
	c=a+b	Book Value of Total Capital	$227,000,000
	Wd=a/c	Weight of Debt in the capital structure	0.118942731
	We=b/c	Weight of Equity in the capital structure	0.881057269
	Cd	After Tax Cost of Debt=	4.80%
	Ce	Cost of Equity =Required Return	12.25%
		After Tax Weighted average Cost of Capital:
		WACC=Wd*Cd+We*Ce=	11.36%
		WACC BASED ON MARKET VALUE	11.36%
		CALCULATION OF WACC BASED ON TARGET CAPITAL STRUCTURE
	Wd=a/c	Weight of Debt in the target capital structure	0.35
	We=b/c	Weight of Equity in the target capital structure=1-0.35=	0.65
	Cd	After Tax Cost of Debt=	4.80%
	Ce	Cost of Equity =Required Return	12.25%
		After Tax Weighted average Cost of Capital:
		WACC=Wd*Cd+We*Ce=	9.64%
		WACC BASED ON MARKET VALUE	9.64%
		SUM OF THESE THREE WACCS=9.77+11.36+9.64=	30.77%