Question

Won’t Quit has 1 million shares of common stock outstanding with

a market price of $12 per share. The firm's outstanding bonds have

ten years to maturity, a face (book) value of $5 million, a coupon

rate of 10%, and currently sell for $985 per $1000 of face value. The

risk

-

free rate is 7%, and the expected return on the S&P 500 is 14%.

The firm pays taxes at the rate of 40%, and their stock has an

estimated beta of 1.2.

What’s your estimate for Won’t Quit’s WACC?

Answer 1

MV of equity=Price of equity*number of shares outstanding

MV of equity=12*1000000

=12000000

MV of Bond=Par value*bonds outstanding*%age of par

MV of Bond=1000*5000*0.985

=4925000

MV of firm = MV of Equity + MV of Bond

=12000000+4925000

=16925000

Weight of equity = MV of Equity/MV of firm

Weight of equity = 12000000/16925000

W(E)=0.709

Weight of debt = MV of Bond/MV of firm

Weight of debt = 4925000/16925000

W(D)=0.291

Cost of equity

As per CAPM

Cost of equity = risk-free rate + beta * (expected return on the market - risk-free rate)

Cost of equity% = 7 + 1.2 * (14 - 7)

Cost of equity% = 15.4

Cost of debt

K = N

Bond Price =∑ [(Annual Coupon)/(1 + YTM)^k]     +   Par value/(1 + YTM)^N

k=1

K =10

985 =∑ [(10*1000/100)/(1 + YTM/100)^k]     +   1000/(1 + YTM/100)^10

k=1

YTM = 10.2467113081

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 10.2467113081*(1-0.4)

= 6.14802678486

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

WACC=6.15*0.291+15.4*0.709

WACC =12.71%