Question

If Wild Widgets, Inc., were an all-equity company, it would have a beta of 1.10. The company has a target debt-equity ratio of .75. The expected return on the market portfolio is 11 percent and Treasury bills currently yield 3.6 percent. The company has one bond issue outstanding that matures in 29 years, a par value of $2,000, and a coupon rate of 6.3 percent. The bond currently sells for $2,100. The corporate tax rate is 22 percent.

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

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

c. What is the company’s weighted average cost of capital?

Answer 1

Answer of Part a:

Face Value = $2,000
Current Price = $2,100

Annual Coupon Rate = 6.3%
Annual Coupon = $2,000 * 6.3% = $126

Time to Maturity = 29 years

Let annual YTM be i%

$2,100 = $126 * PVIFA(i%, 29) + $2,000 * PVIF(i%, 29)

Using financial calculator:
N = 29
PV = -2,100
PMT = 126
FV = 2,000

I = 5.93%

Annual YTM = 5.93%

Before-tax Cost of Debt = 5.93%
After-tax Cost of Debt = 5.93% * (1 - 0.22)
After-tax Cost of Debt = 4.63%

Answer of Part b:

Risk free rate = 3.6%

Expected Market Return = 11%

Beta = 1.10

Cost of Common Equity = Risk-free Rate + Beta * (Expected Market Return – Risk free rate)
Cost of Common Equity = 3.6% + 1.10 * (11% - 3.6%)
Cost of Common Equity = 3.6% + 8.14%
Cost of Common Equity = 11.74%

Answer of Part c:

Weight of Debt = 0.75 / 1.75
Weight of Debt = 0.4286

Weight of Common Stock = 1/1.75 = 0.5714

WACC = Weight of Debt*After-tax Cost of Debt + Weight of Preferred Stock*Cost of Preferred Stock + Weight of Common Stock*Cost of Common Stock
WACC = 0.4286*4.63% +0.5714*11.74%
WACC = 1.98% + 6.71%
WACC = 8.69%