Question

Aaron's Rentals has 50,000 shares of common stock outstanding at a market price of $38 a share. The company has a beta of 1.2 and the market risk premium is 8%, with risk free rate of 3.5%. The outstanding bonds mature in 10 years, have a total face value of $800,000, a face value per bond of $1,000, and a market price of $987.60 each. The bonds pay 6% coupon. The tax rate is 30 percent. What is the firm's weighted average cost of capital?

Answer 1

Cost of equity= risk free rate + market risk premium * beta

= 3.5% + (8% *1.2)

= 13.1%

The Approximate Yield to Maturity Formula =[Coupon + ( Face Value - Market Price) / Number of years to maturity] / [( Face Value + Market Price)/2 ] *100

= [$ 60+ ( $ 1,000- $ 987.60) /10] /[( $ 1,000+ $987.60 )/2] *100

= 61.24/ 993.8*100

= 6.16%

Note : Coupon = Rate * Face Value

= 6% * $ 1,000

= $ 60

Since this formula gives an approximate value, the financial calculators can be used alternatively.

where,

Par Value = $ 1,000

Market Price = $ 987.60

Annual rate = 6% and

Maturity in Years = 10 Years

Hence the yield to maturity = 6.17%

Now, the after tax cost of debt = Yield to Maturity * (1- tax Rate)

= 6.17% * ( 1-30%)

= 4.319%

Value of equity = 50,000 shares * $ 38

Value of debt = ($ 800,000 / $1,000) * $ 987.60

Total Value = Value of equity + Value of Debt

WACC = (Cost of Debt * Weight of Debt) + (Cost of Equity * Weight of Equity)

= 10.52%

Answer : 10.52%

Note:

	Value	Weight(value / total)	Cost	Weight * cost
Equity	1900000	0.706298697	13.1	9.25
Debt	790080	0.293701303	4.319	1.27
Total	2690080			10.52